Do We Need Big Banks?

In the past several decades banks have grown relentlessly. Many have become very large—both in absolute terms and relative to their economies. During the recent financial crisis it became apparent that large bank size can imply large risks to a country’s public finances. In Iceland failures of large banks in 2008 triggered a national bankruptcy. In Ireland the distress of large banks forced the country to seek financial assistance from the European Union and International Monetary Fund in 2010.

An obvious solution to the public finance risks posed by large banks is to force them to downsize or split up. In the aftermath of the EU bailout Ireland will probably be required to considerably downsize its banks, reflecting its relatively small national economy. In the United Kingdom the Bank of England has been active in a debate on whether major U.K. banks need to be split up to reduce risks to the British treasury. In the United States the Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) passed in July 2010 prohibits bank mergers that result in a bank with total liabilities exceeding 10 percent of the aggregate consolidated liabilities of all financial companies, to prevent the emergence of an oversized bank.

So public finance risks of systemically large banks are obvious. But what are some of the other costs (and benefits) associated with bank size? This is the question Harry Huizinga and I try to address in a recent paper. Specifically, we look at how large banks are different in three key areas:

• Do they have different performance in risk and return outcomes?
• Do they have different business models for their activity mixes and funding strategies?
• And are larger banks subject to greater or less market discipline than smaller banks?
   

We investigate these issues for a large sample of international banks in 80 countries over the years 1991–2009. The international sample has the advantage of allowing us to distinguish between a bank’s absolute size—as measured by the logarithm of its assets—and its systemic size—as measured by the ratio of its liabilities to GDP. These two measures are correlated, but only at 10 percent. A large bank need not be systemically large if it is established in a large economy; similarly, a relatively small bank can be systemically large if it is located in a small economy. As figure 1 shows, most banks in the sample are small relative to GDP: 87 percent have a liabilities-to-GDP ratio of less than 5 percent. Nevertheless, 8 percent of all banks in the sample have liabilities that exceed 10 percent of GDP, and almost 1 percent have liabilities greater than the GDP of their home country.

Figure 1. Distribution of sample banks by liabilities-to-GDP ratio

Note: The figure shows the banks sorted into successive bins based on the size of their liabilities-to-GDP ratio; the numbers above the bars are the percentage of banks in each bin. The banks with a ratio larger than 1 are represented in the bin on the right.

We find that a bank’s rate of return on assets increases with its absolute size but declines with its systemic size. Bank risk increases with absolute size but appears to be largely unaffected by systemic size. So a bank’s absolute size represents a trade-off between bank risk and return. Systemic size, on the other hand, is an unmitigated bad, since it reduces return without a clear impact on risk. In practice, a bank determines its absolute and systemic size jointly if it remains established in the same country. This implies that banks located in larger economies may have a larger optimal size as determined by a risk and return trade-off, since such banks can increase their absolute size with a relatively small negative impact on systemic size.

In terms of business models, we see that large banks appear to be relatively active on capital markets on both the asset and the liability side of the balance sheet. Larger banks obtain a larger share of their income in the form of noninterest income such as trading income and fees. They also hold a relatively small share of their assets in the form of loans rather than, for instance, securities, and they attract a relatively large share of their short-term funding in the form of nondeposit or wholesale funding. We don’t see these tendencies for banks that are just systemically large.

Finally, a major issue is how size affects market discipline. Large size may render a bank too big to fail, reducing its funding cost. On the other hand, given tight public finances, systemic size may make a bank too big to save, increasing its funding cost. At the same time, a bank’s too-big-to-fail status may make its interest cost less sensitive to a proxy for bank risk such as its capitalization rate, while a bank’s too-big-to-save status can make its interest cost more sensitive to bank risk. Empirically, we find that the sensitivity of a bank’s interest cost to proxies for bank risk rises with the bank’s systemic size, while this sensitivity is not significantly related to absolute size.

Thus we find evidence of market discipline on the basis of systemic size consistent with the view that systemically large banks may become too big to save, while we find no international evidence of reduced market discipline on the basis of a too-big-to-fail status due to larger absolute size. Our finding that a bank’s interest cost tends to rise with its systemic size can in part explain why a bank’s rate of return on assets tends to decline with systemic size.

Our findings have important policy implications in the light of current debate on the desirability of large banks. In practice, bank managers have made the decisions that have led to the considerable growth of banks around the world in the past two decades or so. This is prima facie evidence that such growth was in the interest of bank managers. Large bank size can benefit bank managers because it likely boosts their status and pay.

It is less clear that large bank size is in the interest of bank shareholders. Our results suggest that bank growth may increase a bank’s rate of return in relatively large economies, but even then at a cost of more bank risk. In smaller economies bank growth may have reduced bank return on assets and increased bank risk. These findings suggest that bank growth has not been in the interest of bank shareholders in smaller economies, while there are doubts whether shareholders in larger economies have benefited.

If bank growth comes at the expense of bank shareholders, how did today’s systemically large banks ever become so large? One possibility is that inadequate corporate governance structures at banks may have enabled managers to pursue high-growth strategies at the expense of shareholders.

If so, the question arises whether preventing banks from growing to a large systemic size can be left to market discipline or should be the object of regulation. Our evidence indicates that market discipline on the basis of systemic size does exist. But we know that this market discipline—in the form of higher funding rates—was not effective in preventing the emergence of banks in many countries that are very large relative to the national economy.

In the absence of effective market discipline, regulatory intervention appears to be called for. This could take the form of higher taxation of, say, the profits or liabilities of systemically large banks or direct intervention that forces systemically large banks to downsize or split up. In addition, reform of corporate governance and pay structures at banks would be useful to ensure that market discipline can be effective. Managers should have incentives to heed market signals, and they should be rewarded for keeping their banks safe rather than for pursuing high-growth strategies at the expense of shareholders.

Further Reading:

Demirgüç-Kunt, Asli, and Harry Huizinga. 2011. “Do We Need Big Banks? Evidence on Performance, Strategy and Market Discipline.”