Why Big Banks Will Get Bigger

FLORENCE – Severe banking crises bring painful and long-lasting disruptions. But they also lead to surprises. The lessons learned in the immediate aftermath bear little relationship to the eventual outcome. There are immediate and obvious answers to the question of who was to blame, but they rarely correspond with the new shape of the financial landscape that ultimately emerges.

The crisis that began in 2007 originated in the sub-prime mortgage sector in the United States, and in US banks that were “too big to fail,” prompting many observers at the outset to predict the end of American financial capitalism. But the banks that were most affected were elsewhere, and the long-term winners will be a few American banks – including some of the most notoriously weak banks – which will get bigger as a result of the crisis. Fueled by the injection of taxpayers’ money, American capitalism is back in force.

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The explanation of why the obvious lessons of the crisis are being not drawn lies in the curious character of financial activity. Banking is inherently competitive; but at the same time, it is not an industry where competition ever worked very well.

The core of financial activity depends on reputation, information networks, and the ability to make markets as well as trade on them. The result is that there are indisputable advantages to being big, as well as the disadvantages that have become obvious over the past two years. The market tends to be dominated by a relatively small number of firms.

In the old days, when banking was stable and regulated securely in a national setting, three or four leading banks tended to form an oligopoly: Barclays, Lloyds, Midland, and National Westminster in the United Kingdom; Commerzbank, Deutsche, and Dresdner in Germany. There were always suspicions of formal or informal banking cartels, which would agree on conditions and interest rates. Regulators generally turned a blind eye to these suspicions.

In the 1990’s and 2000’s, internationalization promised to produce a new landscape, in which a small handful of banks would once again divide up a single global market. Banks maneuvered to get the best position to take advantage of financial globalization, which usually meant locating themselves where the regulatory regime was least restrictive.

Banks got much bigger very quickly, and bigness brought problems. As they grew, banks found it difficult to manage the multiplicity of their divergent activities. They were beset with incompatible computer software systems, rogue employees, and the need to account for the different national cultures in which they were now operating.

Almost inevitably, the biggest banks in the world got into trouble. In the 1990’s, the largest banks were mostly Japanese. Who now remembers Daiichi Kangyo?

The financial crisis has produced a new answer to where the greatest competitive advantages lie. From banks’ perspective, the most obvious lesson was the need for a strong national government to bear the potential costs of a rescue. It is no longer best to be subject to the most favorable regulatory regime, but to be where the state has the deepest pockets.

Very large banks in small territories with small-scale governments are vulnerable. The US is big enough to handle behemoths like Bank of America or Citigroup. China can handle its large banks, even if they have large portfolios of poor credits.

European banks are in a more precarious situation. Ireland and Iceland have become notorious cases where a financial sector metastasized and destroyed the host country. Even in France and Germany, large and internationally active banks potentially exceed the government’s capacity to mount a rescue. In addition, there is the complexity of disentangling which country is responsible for what part of a rescue, when, for instance, Central European banks are controlled by an Austrian bank that is bought by a German bank that is then bought by an Italian bank.

As a result, the big transnational institutions are lobbying hard for a pan-European approach to banking supervision and regulation (and implicitly for fiscal bailouts should that supervision and regulation fail).

In the case of the banks that required state rescues, European competition rules are requiring divestment and downsizing. Institutions such as Royal Bank of Scotland, which for a time in 2009 headed the list of the world’s largest international banks, are being pruned by the EU’s Directorate General for Competition.

Even the stronger banks are being pressed to increase their capital reserves. In most cases, this means that they will continue to cut back on lending, worsening the impact of the financial crisis on the rest of the economy.

By contrast, in the US, the government pushed big banks into buying up smaller and vulnerable banks, and is now doing everything it can to press them to lend more.

Government reactions are full of paradoxes. The more we insist that a banking system should be competitive, the greater the risks that individual banks will take. The more governments are prepared to step in, and the greater the resources of those governments, the more big banks and big countries will be favored.

The last 20 years of globalization saw the emergence of small, open economies as global leaders. The next 20 years will see a different globalization, in which the winners are large, powerful countries that mobilize government resources in the interest of creating winners in the race for financial supremacy.