Geithner: We Need Big Banks To Be Even Bigger

“I don’t have any enthusiasm for … trying to shrink the relative importance of the financial system in our economy"

Timothy F. Geithner

According to the man running U.S. economic policy, American banks need to be even bigger in order to take advantage of the ‘financial deepening’ that is anticipated in emerging markets. So, no, Geithner says, don’t shrink the big banks. Make them even bigger.

The problem with this view is that it ignores recent history and all available economic research on bank size. Take the latest study from VoxEU economists for example:

In recent years, many banks have reached enormous size both in absolute terms and relative to their national economies. By 2008:

  • 12 banks worldwide had liabilities exceeding $1 trillion, and
  • 30 banks had a ratio of liabilities to national GDP higher than 0.5.

Large banks tend to be too big to fail, as their failure would have hugely negative repercussions for the overall economy.

Saving oversized banks, however, may ruin a country’s public finances (Gros and Micossi 2008). Take the example of Ireland; this country provided extensive financial support to its large banks and subsequently had to seek financial assistance from the EU and the IMF in 2010. The public finance risks posed by systemically large banks suggest that such banks should be reduced in size.

Further evidence against big banks can be found from studies on banking technologies. Berger and Mester (1997) estimate the returns to scale in US banking using data from the 1990s, to find that a bank’s optimal size, consistent with lowest average costs, would be for a bank with around $25 billion in assets. Amel et al. (2004) similarly report that commercial banks in North America with assets in excess of $50 billion have higher operating costs than smaller banks. These findings together suggest that today’s large banks, with assets in some instances exceeding $ 1 trillion, are well beyond the technologically optimal scale.

Do we need big banks?, VoxEU

The economists go on to suggest that bank size may be a function of corporate governance and agency problems. Specifically, the larger the bank, the larger the prestige and remuneration for top bank managers. This is true irrespective of whether bank shareholders benefit, meaning this is a classic agency problem where bank managers and bank owners’ interest may diverge. And as we witnessed during the crisis, bank stocks swooned as the system collapsed. But most top bank managers walked away with tens of millions without penalty or sanction. That’s how it has worked up until now.

The economists proffer that banks should be limited not just by regulation, but also by bank levies and corporate governance reform.

Good luck with these suggestions. U.S. economic policy is not heading in that direction:

Geithner hunched his shoulders, pressed his knees together, and lifted his heels up off the ground—an almost childlike expression of glee. “We’re going, like, existential,” he said…

[W]e have to think about the fact that we operate in the broader world,” [Geithner] said. “It’s the same thing for Microsoft or anything else. We want U.S. firms to benefit from that.” He continued: “Now financial firms are different because of the risk, but you can contain that through regulation.” This was the purpose of the recent financial reform, he said. In effect, Geithner was arguing that we should be as comfortable linking the fate of our economy to Wall Street as to automakers or Silicon Valley.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.