by Donald P. Morgan – Liberty Street Economics, Federal Reserve Bank of New York
The chorus of criticism levied against mega-banks has, in some cases, outrun the research needed to back the criticism. To help the research catch up with the rhetoric, financial economists here at the New York Fed have engaged in a systematic study of the economics of large and complex banks and their resolution in the event of failure. The result of those efforts is a collection of eleven papers, each of which was subject to review (internal and external). The papers are now online in our Economic Policy Review. Today, we begin a two-week series of posts that present the key findings of each paper. Here, I’ll give a taste of each and some of the essential points delivered by them.
Thanks
Before proceeding, the whole team would like to thank Darrell Duffie, Mark Flannery, Scott Frame, Joe Hughes, Jack Reidhill, David Skeel, and Phil Strahan for their help in refereeing the papers. Their detailed critiques, swiftly rendered, greatly improved our product. Mark Flannery deserves special thanks for refereeing multiple papers. Naturally, the referees aren’t to blame if you don’t agree with the papers.
Now to the content. While contributors took a wide-angle approach to the issue, the papers fit, without too much shoving, into one of three topics: size (and costs and benefits thereof), complexity (sources and measurement), and resolution. These three topics are, of course, closely related; given the size and complexity of a bank, whether it’s too big or complex to let fail depends on the resolution “technology†(DeYoung et al. 2001) available to regulators. The more efficient the technology, the larger and more complex the bank can be without its failure having systemic consequences. I discuss each paper in the order in which its associated blog post appears.
Bank Size, a Double-Edged Sword
Until recently, having mega-banks seemed like an unmitigated bad; they create systemic risk and there was little convincing evidence of economies of scale beyond a relatively small size. However, just in the last five years several papers have found scale benefits even for trillion-dollar banks. The first paper in the volume, “Do Big Banks Have Lower Operating Costs?†by Anna Kovner, James Vickery, and Lily Zhou, contributes to that recent literature by showing that bank holding company (BHC) expense ratios (noninterest expense/revenue) are declining in bank size. In a back-of-the-envelope calculation, the authors estimate that limiting BHC assets to 4 percent of GDP, as has been advocated, would increase noninterest expense for the industry by $2 billion to $4 billion per quarter. Breaking up mega-banks is not a free lunch.
The other edge of the sword, of course, is the potential funding advantages and moral hazard associated with being perceived as too big and complex to fail (TBTF). A paper by João Santos, “Evidence from the Bond Market on Banks’ ‘Too-Big-to-Fail’ Subsidy,†adds to the growing literature that tries to quantify the TBTF funding advantage, but Santos adds a twist; he tests whether all very large firms, including nonfinancial firms, enjoy a funding advantage. He finds that, in fact, the very largest (top-five) nonbank firms also enjoy a funding advantage, but for very large banks it’s significantly larger, suggesting there’s a TBTF funding advantage that’s unique to mega-banks.
