Scale Economies in Banking and Financial Regulatory Reform

Global financial markets will be shaped for years to come by the regulatory reforms being implemented in response to the recent financial crisis. In my view, two key principles should guide reform efforts. First, reforms should take into account the incentives they create and their longer-run consequences. Second, reforms should harness market forces, not work against them. U.S. policymakers have sought to foster stability by lowering the probability of a crisis and by reducing costs imposed on the rest of the economy when a shock hits the financial system. An important part of their deliberations has concerned financial firms deemed too big to fail or too interconnected to fail. I believe that, ironically, the United States will have a more stable financial system if failing firms are permitted to fail instead of being rescued. Policymakers therefore need a way to allow a financial firm—of any size—to fail without precipitating a crisis. For this, a realistic “resolution” mechanism—a means of restructuring or dissolving a firm’s assets and liabilities—must be created. A credible mechanism must impose losses on creditors as well as shareholders and do it in a consistent manner so that stakeholders expect this imposition and have incentive to take adequate precautions against failure. The mechanism should be transparent and rule-based, giving regulators less discretion, not more.2 A related issue is how to deal with large or interconnected financial firms before they get into financial trouble. There has been a striking amount of consolidation in the banking industry in the United States and abroad over the past 30 years, and it has led to some very large banks. In the United States, the number of commercial banks has fallen from about 14,000 in 1980 to fewer than 7,000 today.3 Even as new banks have entered the industry, there have been over 12,000 bank mergers since 1980, and today, each of the three largest bank holding companies (BHCs)—Bank of America, JPMorgan Chase and Citigroup—has over $2 trillion in assets. Size is not the only indicator of systemic importance: Some institutions are small but important because of interconnections with other financial firms; others are organizationally very complex.4 Some argue that the best way to handle banks that are too big to fail is to break them up.5 To evaluate such a solution, it is important to know why banks have gotten so large. Research suggests that some institutions have gotten large, not to game the system, but for reasons of efficiency. The systemic risks posed by large, complex institutions might still outweigh the efficiencies gained by scale, but without estimating these efficiencies, it is impossible to compare costs against benefits. Moreover, the effectiveness of size limits depends on knowing the market pressures on banks that encourage growth. The literature on scale economies in banking, including my own studies, suggests that imposing a strict size limit would have unintended consequences and work against market forces—contrary to both of my guiding principles for regulatory reform. To my mind, a better solution than legislative limits on bank size is to develop a credible resolution mechanism coupled with other reforms, including revised capital requirements that involve contingent capital and capital charges based on the firm’s contribution to systemic risk, increased disclosures from financial firms, consolidated supervision of large nonbank financial firms, and systemicrisk-focused supervision.