Thursday, April 8, 2010

Big Banks

The too-big-to-fail problem is clearly at the heart of the recent financial crisis. Obviously, our policymakers believe that some financial institutions are so large and "systemically important" that they cannot be allowed to be fail, the large financial institutions in question understand this, and the result is a moral hazard problem. Through some failure of financial regulators to use their endowed powers, insufficient regulations, or due to the ability of financial institutions to evade regulatory scrutiny, large financial intermediaries took on more risk than was socially appropriate. This caused, or at least exacerbated, the financial crisis.

Leaving aside the issue of what should be done about large non-bank financial institutions (a key problem in itself), what should be done about the too-big-to-fail problem associated with large US banks? If we think too-big-to-fail is a problem, then it is clear that the problem is getting worse. As Ned Prescott (Richmond Fed) pointed out in a discussion at a recent conference at the Philadelphia Fed, the number of US banks has fallen dramatically recently, and concentration has increased - a larger fraction of market share is accounted for by the largest banks. There are potentially two reasons for this. First, with the deregulation of the US banking industry - the dismantling of various barriers to setting up additional branches and otherwise expanding individual banks - banks can reap the returns from economies of scale. Second, to the extent that there is too-big-to-fail, large banks are implicitly subsidized.

In my opinion, some economists tend to overemphasize the second effect, and want to lead us to believe that economies of scale are no big deal in banking activity. Certainly my old friend John Boyd (U. of Minnesota Finance Department) thinks this way. Others with this attitude are Simon Johnson and James Kwak, who have written here about it. Their proposed solution to too-big-to-fail is breaking up the large banks, much like we broke up ATT in 1984. For some econometric evidence on economies of scale in banking see this paper by David Wheelock and Paul Wilson.

There are still many small banks in the US, mainly due to historical accident and regulation. US banking started as a system where banks were chartered and regulated by state governments and typically restricted to operating within the state - sometimes restricted to one establishment (a unit bank). It was not until after the Civil War that we had a system that included National banks, regulated by the OCC (Office of the Comptroller of the Currency). A key problem with a unit banking system is that a local bank with loans collateralized primarily by local real estate is risky - it is poorly diversified and will fail with high probability. Diversification is where the economies of scale in banking come from. A large bank that can branch nationally is better diversified, and therefore more efficient.

How do we pool risk and get the diversification we need from a unit banking system that cannot provide it on its own? Securitization. For example, in the mortgage market, Fannie Mae and Freddie Mac did a tolerable job of creating a set of standards for conforming loans that mortgage lenders met, with the mortgages sold to Fannie Mae and Freddie Mac, bundled as tradeable securities, and then held and traded by various financial institutions. There is some loss in efficiency relative to a system with large banks, though, as local mortgage lenders have little discretion about who to lend to. They may have good information that a borrower is creditworthy, but if the borrower does not fit the Fannie Mae cookie cutter profile, he or she does not get a loan. Further, as became clear with the subprime crisis, securitization can be associated with some severe incentive problems, which we are painfully aware of now. In addition, Fannie Mae and Freddie Mac, due to political pressure, ineptitude, corruption, or some combination of the three, relaxed its standards, and had to be taken over by the federal government.

Large banks that branch nationally can clearly avoid the incentive problems associated with securitization. Loans are originated and held by a given bank, and loan officers who do a poor job of screening loans suffer termination, unlike the fly-by-night mortgage broker villains of the financial crisis. Does such a banking system exist? Of course, everyone knows that. Our neighbors (and my friends and relatives) in the Great White North have what appears to be one such first-rate banking system. The Canadian banking system is dominated by the five largest banks - the Royal Bank of Canada, the Toronto Dominion Bank, the Bank of Nova Scotia, the Bank of Montreal, and the Canadian Imperial Bank of Commerce. Indeed, where I grew up, a town of 10,000 people at the time (Cobourg, Ontario), there was one of each. These five banks have been around (or the banks that merged to yield these giants have been around) since the 19th century, and they are remarkably stable. There have been a total of three chartered bank failures in Canada since 1900 - one in the 1920s and two small regional bank failures in the 1980s. Canada has had deposit insurance since 1967, but apparently the CDIC (Canadian Deposit Insurance Corporation) does not have much to do. There were no bank failures in Canada during the Great Depression, and Canadian banks received no direct government support (outside of the essentially zero interest rate policy of the Bank of Canada) during the financial crisis. Further, the Canadian banking system is apparently not some slothful oligopoly. They compete successfully in international financial markets, and have always been well ahead of the average US bank in terms of electronic banking - for example the use of checks (or cheques in appropriate Canadian English) faded long ago.

Looks pretty good, right? Well, not according to Peter Boone and Simon Johnson, who write here. The gist of this piece is that (i) Canadian banks may look safe, but they are actually highly levered and risky; (ii) Canadian banks are subsidized by government-provided mortgage insurance; (iii) Even if we wanted a Canadian banking system in the US, we couldn't have it anyway.

Boone and Johnson state that "Canadian banks were actually significantly more leveraged — and therefore more risky — than well-run American commercial banks." First, given the distortions in the rest of the piece, I'm suspicious about Boone and Johnson's leverage numbers. However, suppose I think that the leverage comparisons they report are accurate. Any good Sloan School Professor should know that leverage and risk are not the same thing. For example, a bank that holds only treasury bills could be very highly levered and essentially riskless - riskiness of the bank is determined by capitalization and the riskiness of the asset portfolio. The financial crisis ran the stress test on Canadian banks - they just can't be characterized as risky. Notice as well in the Boone and Johnson piece that they pick and choose their banks. Obviously they're not making comparisons to Bank of America, Citigroup, or Wachovia (oh right, that one doesn't exist anymore).

Next, Boone and Johnson say: "If Canadian banks were more leveraged and less capitalized, did something else make their assets safer? The answer is yes: guarantees provided by the government of Canada." Any mortgage made by a Canadian bank with less than a 20% down payment must be insured, and the insurance is provided by a government agency, CMHC (the Canada Mortgage and Housing Corporation, which has a role something like the FHA). CMHC provides the mortgage insurance, and the bank that makes the mortgage loan pays the insurance premium. If the mortgage-holder defaults, CMHC pays off the bank.

To understand what is going on here, we have to go deeper into Canadian banking regulation. My hypothesis is that the Canadians have somehow solved the too-big-to-fail problem. The banks are too-big-to-fail, but they never fail, so problem solved. How do they do it? Canadian banks are regulated by the Office of the Superintendent of Financial Institutions (OSFI). Apparently, there is ONE banking regulator, rather than the highly inefficient alphabet soup of overlapping and competing regulators we have in the US. In Canada, the Bank of Canada collects banking data, and the Bank of Canada and the CDIC cooperate with OSFI, but it is OFSI that has the regulatory authority. Further, OSFI also regulates insurance, and guess what? OSFI regulates the mortgage insurance activity of CMHC. There may be some subsidy implicit in the CMHC insurance, since CMHC is in part a vehicle for direct government lending and some of that subsidy may spill over. However I can't see that it's the big deal that Boone and Johnson want to make it out to be. The mortgage insurance certainly looks redundant - the banks seem quite capable of diversifying the risk on their own - but it looks relatively innocuous.

Boone and Johnson want to conclude that embracing large banks in the US, and simply doing a better job of regulating them, is a recipe for disaster. Baloney. Why not figure out what OSFI does, try to replicate it, do away with Fannie and Freddie, and do what we can to discourage mortgage securitization? Economizing on the replication in regulation in the US would be nice, but you can't have it all.


  1. I enjoyed your refutation of the Boone-Johnson post (although I think your comment about Boone's Dr status was gratuitous). As I understand it, one of your rebuttals is that Canadian regulation is more effective. But the two authors (and particularly Johnson) raise another issue which may be relevant.

    As you pointed out, Simon Johnson is concerned that the US Banking system is an oligarchy. His concern is that the US banks may wield undue influence on banking regulation. Moving to Canada, it is clear that the Canadian banking system is composed of an oligarchy (with some smaller players). Do you not think that the Canadian banks might at some point influence the Canadian regulators unduly? For instance about a decade ago, the four of the banks lobbied hard to be allowed to merge. They were stymied at the time, but in the future do you not think that the banks might successfully lobby for a change which boosts their profitability, but unduly decreases the system's stability?

  2. You say that the Canadian banks are competitive. As a consumer, I would dispute that: consumer banking fees in Canada are substantially higher than in other countries such as Britain. Canadians needs to pay high fees to withdraw money from ATMs other than their bank's. This is not the case in Britain, for instance. The oligopoly that controls Canadian banking is insufficient competitive to lower prices to the levels seen in countries with more competitive banking systems.

  3. Good points. The costs of having large banks is the potential for undue political influence, and the standard efficiency losses from concentration. This is important to sort out - we need good quantitative work on the benefits of safety vs. these other costs. It's certainly encouraging though, that Canadian regulators were able to prevent mergers that would have created 3 big banks instead of 5. Clearly they thought some line had been crossed. On the consumer-friendly front, I hear you. When I moved to the US, I could see the difference in consumer-friendliness in US banks, just as I could see it in the restaurants. On the positive side, the big 5 in Canada tend to focus on the big players, while the competitive fringe (trust companies, credit unions, caisses populaires) tend to focus on the little guy.

  4. Thanks for the reply Stephen. I agree that good quantitative work would help delineate the costs and benefits of having high concentration in the banking sector.

  5. Well reasoned article. One thing though...

    AFAIK OSFI does not regulate CMHC. I believe CMHC says they follow OSFI guidelines but they are not regulated.

  6. Interesting. CMHC seems to be a Crown Corporation. OSFI is supposed to regulate insurance, but maybe that is only private insurance, and a Crown Corporation isn't regulated in the usual way. I would like to know more about this.

  7. Paul Krugman put up a blog post over the weekend which suggests another viewpoint about oligarchies and stability in the Canadian banking system. His long post discusses aspects of financial reform, but one section might be relevant to Canada. His entire post is here:

    In his review, he mentions the 1930's to the 1970's era, referred to by Gary Gorton as the the Quiet Period, where bank panics were virtually absent from the the US banking system. Gorton suggests that an important part of the stability of that era arose from the fact that banking wasn't competitive. Banks generated a reasonable profit and they chose to be safe and protect franchise varue rather than taking undue risk for a bit of extra return. Obviously the situation subsequently changed.

    Bringing this back to Canada, the big 5 banks dominate the Canadian market and make reasonable returns on their capital in part because the domestic banking sector is not very competitive (take for instance slantendicular's comments about ATM machine fees and the fact that Canadian banks tend to generate most of their profits from personal banking). One could postulate that given the healthy profit these banks already generate, there is little need to take additional risk, especially seeing that if this risk backfires their oligarchy could be threatened and their near guaranteed profit lost.

    So perhaps the oligarchic nature of Canadian bankig promotes stability?

  8. Yes, though I think the stable period in the US is usually interpreted as being due to Glass-Steagall restrictions on banks which were in part relaxed in the Monetary Control Act (MCA) of 1980, and further relaxed in 1999 in the Gramm–Leach–Bliley Act (GLB). The MCA lowered reserve requirements and got rid of restrictions on loan and deposit interest rates, among other things. The GLB allowed bank holding companies to own other financial institutions. Canada does not seem to have any Glass-Steagall-type restrictions on banking, so the logic of Krugman in his blog post (and he quotes Volcker on this) does not appear to be consistent with Canadian experience. Canadian banks should have been going wild. I'll think about this some more and write a blog post on it.

  9. I cringe every time I read that Canadian Banks did not receive any help during the recent crisis. The PMO ordered CMHC to give them 60 billion dollars and receive a bunch of under water mortgages in return. And I wonder how dominant the five big names in banking are; here on the west coast there are two very large credit unions that seem to be as big as any of the east-central banks. If one added up all the credit unions in the country, would they total something significant to the economy?

  10. Thank you again for the reply Stephen. In my suggestion about oligarchies perhaps providing stability, I wasn't trying to use Krugman's entire post as proof, but rather just his reference to Gary Gorton, who suggests that the US Quiet Period absent bank panics arose in part from the lack of competition in the banking sector.

    Translating to Canada, you're right to point out that there was no equivalent to Glass-Steagall in Canada. So why didn't Canadian banks run wild? Part of the answer to that question may be that because the Canadian banking system is not particularly competitive, Canadian banks were more content with the profits they were already generating and chose to not push the envelope to the same degree as their US brethren.

    Undoubtedly other factors (such as prudent regulation) were involved in keeping the Canadian banking stable. But by allowing Canadian banks to maintain an oligarchy which increases profitability, Canadian regulators took away some of the banks's incentive to seek out riskier ventures, which may have been another source of stability.

    Asp: you're right to point out that Canadian banks did receive support during the financial crisis. However, when I talk about the stability of the Canadian banking system, it's a relative argument, where Canadian banks received much less support than other banks around the world (in addition to no Canadian banking and/or being bailed out by the gov't).

  11. Christopher HylaridesApril 21, 2010 at 8:16 PM

    Also, keep in mind that the Canadian banks have made bad investments in the past. They were particularly hard hit during the commercial property collapses of the early to mid 90s that was still in their collective memory when everybody else was going wild on residential properties. For whatever reason, the Canadian banks also have lower turnover at the board level, so longer wisdom/memory remains.

    It was only 3-4 years ago that people were going on about how Canadian banks can't compete as they were having trouble gaining market share in the US to the banks that were spitting out subprime mortgages. Remember how they were going on about how it was time for a "domestic shakeup". We're sure glad that didn't happen now.

  12. Corrections - the bank issuing the loan does not pay the insurance premium. The homeowner buying the home does, and it gets tacked onto the mortgage principle. Not all mortgages are insured, only the highly leveraged ones (I believe insurance is required for over 80% of the home's value).

    And I don't really think insurance qualifies as a subsidy, since the CMHC runs it as a non-profit insurance program...sure it doesn't make them any money, but the premiums are adequate to cover their payouts as well. A private insurer can (and in some cases does) provide the same services. Genworth Financial has long been a private player in the Canadian mortgage insurance market. During the lead up to the financial crisis, AIG also offered mortgage insurance in Canada, and was the only organisation crazy enough to cover 0-down mortgages.

    Exchanging cash for mortgages that they were on the hook for if they failed anyway isn't exactly a subsidy. Also keep in mind that ALL CMHC insured mortgages are can't just walk away from your house if it's worth less than you owe. The only way out is to pay the difference or go through full-on bankruptcy. As a result, underwater mortgages are still quite likely to be paid.

    As for industry dominance, the banking scene in Canada really isn't all that different from the US this way. The biggest players here have similar combined market share to the biggest players south of the border. There are fewer smaller players, but each one tends to be larger.

  13. Good points. For the mortgage market, you bring up something that is very important, which is differences in Canada and the US in how default on a mortgage is treated.