Daniel K Tarullo: Industry structure and systemic risk regulation
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Brookings Institution Conference on Structuring the Financial Industry to
Enhance Economic Growth and Stability, Washington DC, 4 December 2012.
* * *
It is a pleasure to be at Brookings today for this forum on the industrial organization (IO) of
the financial industry. As I have suggested previously, when one considers the significance
of issues concerning industry structure for the design of an effective and efficient regulatory
system to contain systemic risk, it is surprising that relatively little research has been
undertaken in this area, even in the aftermath of the financial crisis.1
Of course, good empirical research takes time, and I welcome this opportunity to contribute
to a discussion of an agenda for research on industry structure. I will begin by briefly
explaining why this agenda is both important and challenging. Then I will address one issue
of particular significance - that of scale and scope economies, especially as they relate to
policy proposals directed at the too-big-to-fail (TBTF) problem in financial markets.
The promise and challenge of an IO research agenda for the financial industry
The value of an IO research agenda for shaping a regulatory system to protect financial
stability lies both in ascertaining costs that may result from specific regulatory measures and
in revealing industry dynamics that may suggest how regulatory measures may be more
effective.
The importance of understanding the costs of various regulatory measures is self-evident. As
I will discuss shortly, IO can help determine the circumstances in which firm size or industry
concentration is associated with economies of scope and scale that carry social benefits. Any
reduction in such benefits would be an unintended cost of financial stability policies.
Conversely, if firm size or industry concentration is found to stem only from market power or
from funding advantages associated with too-big-to-fail policies or perceptions, then some
policies aimed at diminishing systemic risk would have the added benefit of mitigating market
failures.
Less obvious, perhaps, is the potential for IO research to inform financial stability regulation
by illuminating industry dynamics that may not be intuitively apparent. For example, unlike
firms in most other industries, large financial institutions transact with one another on a
nearly continuous basis and regularly maintain contractual relationships carrying substantial
future obligations. The daily operations of most firms in the financial industry depend to a
much greater extent on the conditions of their competitors than do such operations of firms in
other industries. By extending work on patterns of cooperation and competition among firms
in other industries to the financial sector, IO might help shape regulatory structures that can
reduce the potential for contagion during periods of financial stress.2
As important as IO research can be in developing financial regulation, the financial sector is
in key respects sufficiently different from other industries as to limit the relevance of at least
some existing research. In addition to the just-noted contractual interconnectedness of
competing firms, the combination of correlated asset holdings, maturity transformation, and
mark-to-market accounting means that distress at one firm leading to asset fire sales can
create problems at competing firms. Finally, the presence of systemic risk in financial-sector
intermediation adds an important consideration not normally present in IO analysis of other
industries. Thus, as noted earlier, too-big-to-fail problems can affect the analysis. Also,
prudential regulation can create opportunities for arbitrage both among products and
practices in the regulated sector and between the regulated and unregulated sectors.
Although the characteristics of the financial sector may limit the relevance of conclusions
from IO research in other sectors, they do not limit the relevance of the questions about
industry structure and relationships asked by IO economists. They argue, instead, for
combining the IO approach with the specialized learning of finance, a part of economics that
has grown so important precisely because of the manifold ways in which the financial sector
differs from other industries.
Scale and scope economies in the financial sector
There are few topics within IO more familiar than that of scale and scope economies.3 And
there are few reform proposals that have been put forward more regularly since the start of
the financial crisis than those to limit in some manner the scale and scope of financial firms.
Notwithstanding the coincidence of these two facts, there is relatively little recent academic
research on scale and scope economies in the financial sector and almost none pertinent to
the operations of large financial conglomerates.
The sources of scale and scope economies in the financial sector are generally similar to
those found in other industries. Cost-reducing scale economies are available in areas where
fixed costs are reasonably high, such as in information technology and other infrastructure
systems. Network-effect economies are seen in the large distribution networks that allow
securities dealers to offer clients wider sources of funds for issues of debt and equity
instruments. Broad geographic reach allows firms to offer integrated global payments,
collection, or other services to internationally active clients. There may be scope economies
for banks and their customers when a variety of services is provided, thereby reducing
information and other transactions costs. A range of relevant economies can be illustrated
with a simple example.
A firm engaged in merger and acquisitions advisory work needs to assemble a team with
many areas of expertise. A scale economy may be available because the average cost of
advising on a single transaction will be lower if the firm is involved in more transactions, thus
fully employing the team and facilitating greater spillovers of sector-specific information
across transactions. By providing financing for the transaction, the firm may also be able to
achieve a scope economy because its financing activities can leverage off the information
developed by the merger and acquisition adviser, thereby reducing due diligence costs.
Moreover, a client's own transactions costs may be lowered when the firm is able to provide
most or all of the financing because its balance sheet is large enough to fund the acquisition
without breaching applicable internal or regulatory lending limits. Similarly, a client may lower
its transactions costs by using a single firm for both advising and financing.4
The paucity of empirical work means we can only hypothesize these scale and scope
economies, though intuition and observation may make some hypotheses stronger than
others. Even assuming, as I think reasonable, that most or all the economies I have identified
would hold up to empirical assessment, the crucial questions would remain as to how big or
how integrated financial firms need to be in order to attain these economies. The relative
dearth of work that would help answer these questions can be attributed to a number of
factors.5 First, the sample size of the very largest firms is obviously small, limiting the ability
of researchers to derive precise statistical relationships between cost, on the one hand, and
firm scale and scope, on the other. This problem of sample size is exacerbated by the fact
that there has been tremendous growth in the size, complexity, and concentration of the
financial sector over the past 15 years or so. Second, there are serious limitations on the
data available to researchers, and thus any useful discussion of an analytic agenda for
research on financial industry structure must include an agenda for overcoming proprietary
and other constraints on developing appropriate data sources. For example, data on the use
of a variety of financial services by specific customers is generally unavailable to
researchers. Third, even if appropriate data become available, it may be quite difficult to
isolate costs for particular banking activities, given the number of products and activities
offered by even moderately complex financial institutions.
Two additional considerations bear mentioning in mapping out the issues associated with
scale and scope economies in the financial sector. The first is a well-known qualification to
the proposition that scale and scope can be beneficial - the possibility that firms may grow
so large as to face diseconomies of scope and scale. Although existing empirical work is
again scant, one often hears the suggestion that complexity and agency problems may lead
to diseconomies for financial firms under certain circumstances, a proposition that should be
considered alongside the hypotheses for positive scale and scope effects.6
The second point is that the size and composition of a financial firm's balance sheet play a
complicated role in producing economies of scope and scale. To be sure, a large trading
book or custody business might produce social benefits by allowing a bank to match or clear
both sides of transactions at lower cost. And large balance sheets would appear to enable
banks to diversify or hedge their positions and to access a variety of funding sources,
thereby reducing their cost of capital. But conventional IO-type analysis, which would tend to
interpret lower funding costs as evidence of scale economies, is potentially misleading.
in essence, a more sophisticated product to its clients, which may also choose such a firm in part because
they can be assured they have retained the most experienced and knowledgeable advisers. This
phenomenon, familiar in IO studies of a range of service industries, can lead to a "natural" concentration in
certain subsectors, even where scale and scope economies do not suggest that such concentration is driven
by cost efficiencies.
5
A recent study conducted on behalf of The Clearing House tackles some of these questions. This study makes
a useful effort to estimate separately scale and scope economies for a variety of financial activities, rather than
inferring such economies from firm-level consolidated data. However, the study exemplifies some of the
challenges mentioned in this speech, relying as it does on proprietary data for a small sample of firms, as well
as case studies and interviews, for the empirical analysis. The Clearing House (2011), "Understanding the
Economics of Large Banks (PDF)" (New York: The Clearing House, November 7).
6
There is some research that could provide useful starting points for more focused IO work. For example, a
2010 paper by Klein and Saidenberg finds a discount on profitability and market value for more complex
banks. Because the authors control for bank size, the paper does not squarely address scale and scope
issues, but it pursues the kinds of questions that could usefully be asked in that context. Peter G. Klein and
Marc R. Saidenberg (2010), "Organizational Structure and the Diversification Discount: Evidence from
Commercial Banking," Journal of Industrial Economics, vol. 58 (March), pp. 127-55.
"Agency problems" refers in this context to divergences in the incentives of management and shareholders
that create possibilities for management to make decisions in their own, rather than shareholders', interests,
as well as for potentially expensive monitoring mechanisms for shareholders seeking to limit agency costs.
Consider, in this regard, my observation of a moment ago that a large balance sheet may
reduce a bank's cost of capital. If lower funding costs do result from the diversification of
risks and funding sources made possible by a large balance sheet, they would indeed
suggest the existence of scale economies. But they may also result from the belief of some
counterparties that a firm with a very large balance sheet is TBTF, and thus at least some
liabilities of that firm will be backed by the government in a time of financial stress. In this
instance, lower funding costs actually suggest a market failure induced by the distortion
arising from the implicit government guarantee. In practice, both scale economies and
market failure may play a role.
Although the moral hazard associated with TBTF funding is a significant issue, it is also
reasonably discrete and susceptible to countervailing policy measures such as capital
requirements and credible resolution mechanisms. Some strands of finance research
suggest more profound implications for certain configurations of financial industry structure.
For example, numerous papers suggest that the very large balance sheets of very large
financial firms tend to be highly correlated, such that a shock to certain asset classes is likely
to reverberate quickly on the balance sheets of most large firms as fire sales and subsequent
mark-to-market effects affect even stronger firms.7 If this conclusion is valid, then the
apparent economies associated with very large balance sheets may be transitory or, more
precisely, contingent on the absence of serious shocks to certain asset classes.
It is precisely at this intersection between questions of industry structure and of the behavior
of financial markets that a joint venture between IO and finance is most important. As I noted
earlier, such an effort could not only help fill out an assessment of the social benefits
associated with the size and industry structure of financial firms, but it could also lend insight
into the kinds of measures that may be most effective in containing systemic risk.
Application to specific policy proposals
To illustrate more concretely how analysis of scope and scale economies is relevant to the
development of a regulatory system designed to safeguard financial stability, I want to turn to
three proposals currently being debated in policy circles: (1) breaking up large financial
institutions by reinstating Glass-Steagall restrictions or by imposing other prohibitions on
affiliations of commercial banks with certain business lines; (2) placing a cap on the
nondeposit liabilities of financial institutions; and (3) requiring financial institutions above a
specified size to hold minimum amounts of long-term debt available for conversion to equity
to avoid or facilitate an orderly resolution of a troubled firm.
Breaking up firms by business line
Proposals to reimpose a Glass-Steagall prohibition on affiliations between commercial and
investment banks have been met with the rejoinder that the origins of the financial crisis do
not trace back very clearly to these affiliations. Many firms at the center of the crisis would
have been essentially unchanged had Glass-Steagall been in effect. Bear Stearns, Lehman
Brothers, and Merrill Lynch did not have sizable insured depository institutions, while
Countrywide and Washington Mutual had few if any activities that could be termed
investment banking. Wachovia did have a securities affiliate that was sizable, though hardly
an industry leader, but its downfall seems pretty clearly connected to its exposure to
subprime mortgages that it had written directly or acquired through mergers with other
institutions.
Proponents of breaking up firms by business line may reply that the next financial crisis will
not likely have the same genesis as the last, and that separating commercial from investment
banking could at least mitigate the risks of extending the safety net provided depository
institutions to underwriting, trading, and other activities of very large firms. But an IO
perspective suggests that the proposal could entail substantial costs. The reinstatement of
Glass-Steagall would mean that bank clients could no longer retain one financial firm that
would have the capacity to offer the whole range of financing options - from lines of credit to
public equity offerings - depending on a client's needs and market conditions. Moreover,
many banks that are far too small ever to be considered TBTF do provide some capital
market services to their clients - often smaller businesses - a convenience and possible cost
savings that would be lost under Glass-Steagall prohibitions.8
With the present state of research, it is virtually impossible to quantify the social benefits of
these economies. However, what seems the likelihood of nontrivial benefits from current
affiliations is a good reason to be cautious about adopting this proposal.
Capping nondeposit liabilities
Proposals to place a cap on a bank's nondeposit liabilities as a fraction of U.S. gross
domestic product (GDP) have been promoted as more directly responsive to the sources of
systemic risk than are proposals to reinstate Glass-Steagall or to cap the total assets of a
bank. Many studies of the financial crisis demonstrate that the reliance of large financial firms
on nondeposit funding made them, and the financial system as a whole, susceptible to the
dramatic runs that peaked in the fall of 2008. For the largest U.S. financial firms, nondeposit
liabilities today are highly correlated with the systemic risk measures used at the Federal
Reserve Board to measure interconnectedness and complexity for purposes of evaluating
the financial stability effects of mergers.
Another attraction of this form of proposal is that, even as it places constraints on the
potential size and composition of a firm's balance sheet, it allows relative flexibility to the firm
in meeting that constraint, particularly when compared with proposals for prohibitions on
commercial bank affiliations with other financial firms. A firm could shrink its balance sheet by
shedding less profitable assets of its choosing. It could also shift its funding model more
toward deposits (assuming, of course, it does not exceed applicable deposit caps). There are
also ways to refine the proposal further, such as by weighting the nondeposit liabilities in the
numerator of the ratio based on their duration. In short, as I have previously noted, there is
considerable conceptual appeal in these proposals.9
Nonetheless, there are several important questions raised by the nondeposit cap idea.
Foremost among these is the decision about the appropriate percentage of GDP that would
constitute the cap. The determination of this limit would presumably be based on a number of
considerations, including an evaluation of the capacity of the U.S. economy and financial
system to absorb the losses resulting from the failure of a large firm. Several salient
considerations are also suggested by a combined IO-finance perspective. First, of course, is
the key issue of how the functioning of funding markets is affected by the participation of very
large counterparties using very large amounts of short-term wholesale funding, particularly
under conditions of financial stress. This issue falls more on the finance, rather than the IO,
side of the merged perspective. But it may be that aspects of industry structure, including
some of the competition/cooperation issues mentioned earlier, affect this analysis. Also, an
IO-finance perspective might identify possible alternatives to a nondeposit liability cap that
achieve much the same financial stability goals at lower potential cost.
Second is the question of scale and scope economies associated with nondeposit funding,
the answer to which would help determine the limit at which significant social benefits might
be lost, to be balanced against the avoidance of social costs arising from systemic events.
Even with the flexibility noted earlier, a firm might have to sacrifice certain economies of
scope or scale to meet a cap. If analysis finds scale and scope economies unlikely to be
realized beyond a certain level of activity, then policymakers would have a point of reference
for setting the cap.
A third question is how second- and third-tier institutions might respond as the largest firms
reposition, and perhaps shed, parts of their balance sheets. These institutions may well be
purchasers of assets sold by the largest firms. They may also choose to take advantage of
the lower demand, and correspondingly lower prices, for short-term funding by increasing
their own short-term borrowing. Research might cast light on the extent to which various
forms of a liability cap would affect market structure, the degree to which reduced activities
by some firms would be taken up by others, and how such changes might affect the stability
of the financial system.
In sum, the IO-finance perspective could contribute significantly to an elaboration and
evaluation of this policy proposal. In the process, it could advance what I regard as the most
important remaining task of financial regulatory reform - determining the most effective and
efficient ways to deal with short-term funding markets, often characterized as the shadow
banking system, that are inherently subject to runs.
Requiring minimum levels of long-term debt
Proposals to require large financial firms to hold minimum levels of long-term debt are
offered as a way to facilitate the orderly resolution of such firms. Variations on this general
theme have gathered momentum as the Financial Stability Board, the Basel Committee on
Banking Supervision, and other groups have explored ways to make large financial firms
more readily resolvable, thereby giving national authorities a third choice between the
unattractive options of bailout and disorderly failure.
The basic idea is that the maintenance of minimum levels of long-term debt at the top holding
company level will allow a resolving authority to transfer operating subsidiaries of the failed
firm to a functioning bridge entity, while leaving behind in a receivership the equity and
sufficient long-term debt to absorb the original firm's losses. Eventually, the resolving
authority could recapitalize the bridge entity by exchanging claims of the long-term
unsecured creditors of the parent for equity, long-term debt of the bridge, or both. In the
United States, this approach is consonant with the Federal Deposit Insurance Company's
stated preference for a "single-entry" strategy in dealing with the resolution of systemically
important firms under the orderly liquidation authority of the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank Act). But it is also consistent with variants on
resolution mechanisms being implemented in other jurisdictions around the world.
A minimum long-term debt requirement could lend greater confidence that the combination of
equity owners and long-term debt holders would be sufficient to bear all losses at the firm,
thereby counteracting the moral hazard associated with taxpayer bailouts while avoiding
disorderly failures. To the degree the orderly resolution mechanisms established in the
United States and elsewhere thus command greater credibility, the result should be
enhanced market discipline, which in turn could enhance financial stability.
As with the two other policy ideas, the details of a minimum long-term debt proposal matter
when it comes to assessing costs and benefits. There will surely be some costs associated
with such a requirement (though it is notable that, at present, large U.S. firms have
substantial amounts of long-term debt on their balance sheets). Like a capital surcharge for
the largest, most complex institutions, these costs will fall only on the largest institutions. But
this is by design, in accordance with the principle - reflected in the Dodd-Frank Act - that the
largest, most complex institutions should be subject to stricter regulation precisely because
they are more complex and because their failure would have greater negative externalities
for the financial system and the economy more generally. Thus, if there is a modest effect on
industry structure, it would be an intended - rather than unintended or undesirable -
consequence of the regulation. In general, at least at the levels of minimum long-term debt
that are being discussed in various international forums, the proposal would not seem to
carry significant hurdles to realizing available economies of scope and scale.
Conclusion
My very brief review of these three proposals has tried to show how a combined IO-finance
perspective can contribute to the policymaking process and what priorities for research might
be. For the proposal to reenact Glass-Steagall, that perspective suggested the potential for
considerable social costs. Application of the perspective to the proposal for a nondeposit
liability cap revealed a number of important questions, an analysis of which could help
determine the elements of such a proposal that would be most effective, identify costs, and
possibly suggest alternative means to the same policy goals. In the case of the third
proposal, for minimum long-term debt requirements, the perspective did not immediately
suggest any unfavorable unintended consequences, thereby perhaps strengthening its
appeal as a near-term policy priority.
I have only grazed the surface of useful work that may spring from this hybrid subdiscipline.
And, as with policy-relevant areas in which considerable work has already been done, we will
never have all the analysis we might like before deciding whether to act and, if so, how. That
is the condition that usually prevails in policymaking. But I am encouraged that Brookings
has assembled this forum, which I hope will be a catalyst for much more academic activity in
this area.