Thursday, October 1, 2009

Why TBTF?

"Big banks' risks to the system increase more than proportionately with their size, and these financial giants should pay higher taxes to offset their potential threats to the system, a new study by the Bank for International Settlements says. ... The report, which studied 20 unnamed large banks, also concludes that no single factor can be relied upon to measure the systemic importance of an individual financial institution, and highlights the fact that banks don't need to be large to be systemic. 'A key result is that the contribution of an institution to systemwide risk generally increases more than proportionately with its size,' the paper's authors said. ... In addition, the paper argued that larger institutions should have tighter regulatory standards, by the same reasoning", my emphasis, Natasha Brereton at the WSJ, 14 September 2009, link: http://online.wsj.com/article/SB125287692722706847.html.

This makes no sense. Why should larger financial institutions be riskier? If true, they will have higher capital costs and should shrink to reduce them. Suppose Citibank gets risker as it gets larger. It need not break up to achieve "economies of scale" by getting smaller. Why? The risk is in the assets. It is independent of who owns the assets. All Citibank need do is become a "holding company" of "mini-Citis" Think about it. What's going on here? Bigger financial institutions engage in different activities than smaller ones. That's where the risk comes from, not size. Believe it or not, we covered this issue in George Stigler's Industrial Organization course at Chicago. By the way Vikram Pandit, if Citi paid you $165 million, this idea is worth $1.65 billion. Expect my bill in the morning.

3 comments:

Anonymous said...

The arguement seems to be that the TBTF must retain some capital markets operations to mediate their wholesale customer needs for FX, interest rate and other risks in a "one stop shopping" model.

Why?

I don't understand the rationale that global corporates must be serviced by global money center banks. A bevy of fin services firms could support corporates and add stability through diversity.

I do believe that the TBTF are there to allow the Fed to mediate monetary policy. They could do it through mid size banks, hedgies and money markets but it gets sloppier. And can you imagine a group more afraid of change than the central bank? An audit terrifies them.

IA -- you got a high billing rate.

CrocodileChuck said...

IA is correct-it is the increase in SCOPE that amplifies risk for the (what used to be called) money centre banks-additional lines of business, with new and different types of risk. Another factor: trading in dozens or hundreds of different markets, with different regulatory regimes-it is impossible to monitor the dynamic risk profiles of each of these, from 'Head Office'. Finally, re: Citi-they have grown by acquisition over the last twenty years but never completed the merger integration work. Result: thousands of legacy systems which must be supported, and from which it is fiendishly difficult to extract 'one version of the truth'. Mega banks like 'C' are not only too big-they're flying blind.

ps IA: I want YOUR fee rate

Independent Accountant said...

CC:
At $1.65 billion I work cheap compared to Pandit.