Monday, November 02, 2009

Too big to fail

During the global financial crisis, the regulators discovered the danger of having banks that are too big to fail. The collapse of a large bank would cause other financial institutions to fail, leading to a total collapse of the entire financial system. This is described as "systemic risk".

If this is so dangerous, why did the regulators allowed and encouraged the consolidation of banks in the first place? Even in Singapore, the local banks were forced to merge to become bigger banks.

If I remember the reasoning at that time, it was argued that large banks would be financially stronger and would be able to compete more effectively with other large banks to lower cost for consumers.

But this did not turn out to be the case. The consolidation of banks actually reduced competition and allowed banks to run a cartel to increase banking fees. The large investment banks, provided funds for mergers, acquisations and caused the asset bubble to grow. They made billions of dollars of profits in these "good years".

The lessons are now learnt, but rather late and at great cost to the world economy. The asset bubble grew to be so inflated that it had to find its correct level. This caused the near collapse of the financial institutions. Being "too big to fail", the banks had to be bailed out by the governments.

Going forward, what is a better approach? Smaller banks? More banks?

Tan Kin Lian


shawn said...

consolidation of banks need is good for economy of scale, reducing redundancy and can tap on the best practice.

having said that, being too big to fail is flawed in my view. Take CIT as a case study, FED injected tax payers money to try save the fifth largest commerical lender from failing but to no avail right nw is in the blink for bankruptcy. End results is a waste of taxpayers money and a wider deficit.

Perhaps we should just let the too big to fail to take it own course of action and let it fall. No doubts it will cause financial meltdowns,but that might not necessary be a bad thing.

I am only afraid after all the FED bailouts, too big to fail will still fail in the coming future.

Vincent Sear said...

The culture of small neighborhood banks, known as savings-and-loans in the US, collapased in the 80s Reagan era more spectacularly and costlier than the recent banking crisis. I think that it's not about the system, it's about the people running the system.

Anonymous said...

Now we know we are fool,or have been fooled.

Anonymous said...

The collaspe of the system is very real, and the damage is irreversible. There will ne anarchy and riots on the streets in every city.
The world leaders know that and they will continue to support and bail out the banks.

It would be logical to allow "nature" to take its course:
let the riots begin.
But the cost and risk just too much.

Eventually, perhaps 3-5years.. the system will breakdown.. good luck to all.

wjsim said...

Banks becoming too big to fail is the symptom. It is not the cause for the financial crisis. And there's nothing such as too big to fail anyway. Jim Rogers shouting out load.

Banks merging and growing in size is actually a good thing, in terms of economies of scale and productivity, if the growth is generated by honestly earned money. However, as the latest crisis has shown, the banks' growth was driven by the unstable asset bubble driven by dirt cheap money pumped into the economy by the federal reserve. I think I'm starting to sound like a broken record. :) Particularly for the case of Fannie and Freddie. With the implied government guarantee on these two banks, fear of default was removed from the equilibrium equation and everything just went lopsided.

Tan Kin Lian said...

Here is my observation over the past decade.

Banks were allowed and even encouraged to grow bigger. The purpose was, according to the regulators, to enjoy "economy of scale".

This did not happen. Instead, the banks enjoyed "cartel like power". They increased their bank charges. They depressed interest rates given to savers (mainly due to the easy money given out by central bankers), but they charged high interest rates on credit cards and small businesses.

The banks made huge profits.

Goodbye to "economy of scale". Say hello to "super profits and super rich billionaires".

Anonymous said...

Looking back in Singapore , I think it is a mistake to combine all the local banks to just 3. There was a plan to further reduce to 2!

Anonymous said...

My opinion,

The real reason why the banks collapse is that they got greedy and threw caution to the wind!

It has nothing to do with being too big.

They extended the loans to all and sundry. Even to those who could not afford the loan.

Banks should in the first place be conservative in their lending especially in The USA.

Going forward, I think those banks have instead become super conservative, unwilling to lend.

I think those banks should relax and normalise their lending requirements.

When its time for banks to be cautious, they did not. When its time for banks to lend, instead they become super conservative. What an Irony!

Hiei said...

I tend to agree on that big banks do not benefit consumers. As bank consolidates and becomes bigger, I think the competition is moving towards monopolistic market, which is bad for consumers. They may be "stronger", but when they fell, it hurts more.

Also, as firms grow bigger, I always find a reduction in efficiency and productivity. I think it is just tough to manage big firms. On a micro perspective, one very common example that i face when dealing in big firms is that big firms have too many departments and "heads". It gets very difficult to get simple things done. More than often I am being pushed to many departments before a simple process is to be completed.

Tan Kin Lian said...

It is better for an economy to have a large number of small banks. Each bank should have the primary purpose of serving the community in providing basic banking service and loans to the business community.

There is no need to have large banks. The cost of the technology is quite modest.

This type of banking structure will reduce the risk of "too big to fail". It will also offer competition and bring down the cost.

Some of the smaller banks can use the shared services or common banking systems provided by large IT operators. There is no need for any bank to be mega size to reduce the technology cost.

We have to go back to the old model of small banks serving the community.

Vincent Sear said...

I think that the government encouraging less but bigger local banks is to facilitate expansion abroad. Without a big enough domestic base, it's hard to expand abroad. With too many banks, it's hard for any to build a big base.

Anyway, Singapore banking isn't restricted DBS, OCBC and UOB only. There're qualifying foreign banks that are functionally exactly like the local banks - StanChart, HSBC, Citibank, Maybank, BOC etc. I think that's enough for competition in this small city.

wjsim said...

Ah... I was actually hoping that you might say something about going back to the old model of small banks serving the community. I'm hoping for the very extreme, for banks to issue gold-backed money instead of the central bank. Back to the very first model before fractional banking and central banking. UOB's gold certificates are just short of being legal tender.

The interest rates at smaller banks are indeed much more attractive relatively speaking. CIMB and RHB are another two banks I thought of. Although the rates are much higher, the counter service is really not up to par with the bigger banks. :P Good things much wait...

Vincent Sear said...

It's hard to have a real community bank like US towns had before the 90s. Singapore is so small, any small branch of a big bank in any neighborhood is already de facto a community bank there, unlike in the US, where certain banks could actually be setup to serve certain towns and communities only. Even there, this culture has collapsed with the late 80s banking crisis.

In the UK and Hongkong, there're no centralised currency boards or national reserve boards to print currencies. Central bank BOE and private banks like RBS, HBOS, HSBC and StanChart all print and issue their own currencies, hence the term bank notes in these areas.

In Singapore, we have MAS and BCC which acts like the US Federal Reserve. Therefore, our currency notes are standardised.

The locally owned financial sector has developed to the point when it's concentrated on 3 big banks (DBS/POSB, OCBC & UOB) and 2 big insurers (NTUC Income & GE).

The rest of the biggies are all of foreign origins, StanChart and HSBC (UK/HK), AIG/AIA (US/HK), Prudential (UK) etc. Though notably, Temasek is now the biggest shareholder in StanChart.

Anonymous said...

Is a big mistake to closed OUB.Now we can see the problems surface.For long term more competition is very healthy.

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