Too big to fail, or just right?

As I pointed out on Tuesday, the core operation of a bank is you agree to loan your money to a bank in exchange for a certain amount of interest, the bank then loans out that money to someone else at a greater rate of interest, and the bank makes its money on the spread between what it is paying you, and what its borrowers are paying the bank. Banks don't pay you interest on your money because they like you. They pay you interest on your money because they're loaning it out to borrowers at a higher rate of interest. That is implied in the whole concept of a modern bank. That is an honest business operation. The bank is serving as a means to spread the risk of lending your money amongst multiple borrowers, rather than a single borrower being able to default and cause a 100% loss. In short, when operating properly, a fractional reserve banking system is a means of spreading the risk of loaning your excess capital amongst sufficient people that the risk you'll not be able to get your money back when the loan is due is reduced to a very small amount.

What this implies is that the problem of "too big to fail" is not a problem of bank size, but, rather, of banking regulation. The deal is that the bigger the bank, the less that it will be affected by any single creditor going bankrupt. If a customer that has $100M in outstanding loans goes bankrupt and a bank has 10,000,000 customers and $100B in deposits, that's a $10 loss per customer and 0.1% of the bank's capital gone. If a bank has 100,000 customers and $1B in deposits, however, that's 10% of the bank's capital gone in one fell swoop.

In short, the same efficiencies of scale that result in a health insurance oligopoly mean that a banking system will naturally evolve towards a banking oligopoly because the larger the bank, the smaller the risk to its customers of a default by a borrower unexpectedly defaulting -- and that's what we're seeing.

So why, then, did we see the problems that occurred at the end of 2008 where the big banks had to be bailed out? Well, it's because it was a failure of regulation -- regulators allowed the banks to engage in higher-risk activities, issue higher-risk loans, speculate in higher-risk speculative investment instruments, and the big banks were no more immune to that than any other banks. The answer, then, is to return banks to what they used to be -- retail operations that make their money off the spread between what they pay for money and what they loan money out for -- rather than having banks be gambling institutions that play in the stock markets or collateralized debt markets attempting to make money off of speculative operations. That is how you make "too big to fail" banks really too big to fail -- in the absence of being able to lose spectacularly huge amounts of money via engaging in speculative behavior, the "too big to fail" banks really ARE too big to fail, because there literally is no loan default scenario that would result in them failing. Their risk pool that they spread loans across is literally too big to fail if they aren't allowed to speculate with the money but, rather, must loan money in a sound and safe manner.

Of course, in saying this, I'm puncturing the sacred religions of both right-wing AND left-wing zealots. The right-wingers howl "Regulation! Evil! Heresy! Heresy!", and the left-wingers howl "Banks! Evil! Heresy! Heresy!". So it goes. I'm a rational penguin who looks at the numbers, not at ideology, so I think they're both full of it. We need banks -- there's no other way to keep capital moving through the economy rather than stashed under mattresses where it contributes nothing (zero) to economic activity. Given that, keeping the systemic risks down can be done either by having banks too small to matter, or banks too big to fail, but either way is going to require a lot of regulation -- and too small to matter has its own problem, which is what to do when a too-small-to-matter bank fails and the FDIC can't merge it into another bank because the combined bank *would* be big enough to matter. At that point the whole notion of regulating banks until they're too small to matter fails. Ideology, alas, runs into reality once again. How inconvenient!

-- Badtux the Banking Penguin