In the World of Banking, Does Size Matter?

It was bound to happen. After pouring tens of billions of dollars, pounds and euros: as much as 5.5 per cent of the GDP of advanced economies, according to the International Monetary Fund, governments began to revolt. “If a bank is too big to fail, then it is too big,” the governor of the central bank of Belgium told a newspaper at the end of June. If this is true, then what about the corollary: “Small is beautiful?” If bankers’ bonuses are being capped, should the size of their banks be capped as well?
INSEAD Professor of Banking and Finance Jean Dermine thinks not. And he has some 25 years of research to back it up. “There are two arguments against capping the size of banks,” he says. “The first is, in order to have the economy of scale in the financial sector to service large domestic corporate clients, you must have a large international bank. The Netherlands have Unilever and Shell, for example, and these companies do business around the world.” 

“The second major argument is that if you cut the size of banks they will not be diversified properly. A good example of this is in Spain, where the Cajas, or domestic savings banks, suffered massively from the real estate crisis, and many are close to default. You compare these to Banco Santander who is active in the US, the UK, Latin America (and) you see they have done much better in the crisis because they are diversified.”

In fact, Dermine points out that small banks in trouble are not necessarily less of a problem than their larger counterparts, and the bank equity to home country GDP ratio can be somewhat distorting: the equity of CS is 11 per cent of Swiss GDP; the Royal Bank of Scotland is 5 per cent of UK GDP, while Citibank is 0.8 per cent of US GDP.

“When you look at the data,” Dermine says of his research, “you see that even countries with small banks have large bailout costs. Greece and the United States have many small banks affected at the same time, and the bailout cost was very, very large.”

Foreign currency lending risks proved to be another threat to bank capitalisation. Dermine’s research shows that many banks in Eastern Europe lend as much as 70-80 per cent of their portfolios in foreign currency. In the short term, profits outweighed the risks. For example, as interest rates in Switzerland are lower, the cost of borrowing is lower, until the system starts to crumble and the home currency plummets. “This creates systemic risk,” says Dermine. “Why did banking regulators allow the risk of lending in foreign currencies? I’ll tell you: because in a booming economy, there is no pressure on regulators to stop this lending in foreign currencies. A regulator would have to be very brave to tell bankers ‘we should stop making these loans; we should stop taking these risks’”.

Another reason for such foolhardiness, says Dermine, is a basic assumption on the part of bankers worldwide. “Over the past 20 years, many bank managers felt governments and central banks wouldn’t let banks go into default. They thought the view was that banks shouldn’t be allowed to fail, and this created a major moral hazard.”

That view ended abruptly when the US Treasury allowed the venerable 159-year-old investment bank Lehman Brothers to fail on September 15, 2008. “The idea was to teach the market a lesson,” says Dermine of the massive meltdown. “They had helped JPMorgan take over Bear Stearns a few months earlier, then a few months go by and Lehman Brothers is in trouble. But they knew that putting Lehman into default would not put other major institutions into default. And indeed, international banks have been able to meet the losses linked to their exposure to Lehman.”

Maybe not, but banks were scared witless by the collapse of Lehman Brothers. “Bankers wondered if Lehman was allowed to default, were they going to see other institutions put into default? There was a massive collapse of confidence and bankers absolutely refused to lend to each other. That created a liquidity crisis and that was the start of the banking crisis.” 

Dermine wants to see improved regulation rather than capping bank size as a way of containing financial fiascos in the future. “In a service economy, banks provide a lot of highly-skilled jobs, and we believe it would be the wrong policy to reduce the size of these banks. In the last 10 to 15 years, mathematical advances have allowed better measurement of credit risk, and this led to an explosion of financial products related to credit. The point is, we’ve taken on too much risk.”

Dermine favours an idea that’s being discussed today in the US and the UK which would create special bankruptcy rules for banks: regulators would shut the bank for the weekend and force the conversion of debt into shares, which would substantially increase the bank’s amount of equity when it re-opened Monday morning.

Additionally, Dermine would like to see independence and accountability of supervisory agencies, with banking regulation independent of politics; a prompt and corrective action mechanism; a burden-sharing system so that bailout costs are shared by a group of countries, and an end to the “too-big-to-fail” doctrine, replaced by new bankruptcy rules as outlined above.

Indeed, the shape of the post-crisis financial world supports Dermine’s belief that banking regulation, rather than a cap on bank size, is the way to prevent another meltdown. “The major outcome of the crisis is that some banks are much bigger today. In the case of America, Bank of America has merged with Merrill Lynch, it has bought Countrywide. In the UK, Lloyd’s TSB has become much bigger. BNP Paribas in France purchased Fortis. These are all coming out of the crisis as much bigger institutions. Believing regulators will be better able to manage these and institutions tomorrow without significant changes; I don’t think that’s going to be the case.”
 
Jean Dermine’s book, ‘Bank Valuation and Value-Based Management’, has just been published this autumn by McGraw Hill.

[This article is republished courtesy of INSEAD Knowledge
http://knowledge.insead.edu, the portal to the latest business insights and views of The Business School of the World. Copyright INSEAD 2023]