Does Size Matter?

Simon argued in the Atlantic article, and I argued in “Frog and Toad” and “Big and Small”, that the best way to regulate the financial sector is to limit the size of individual institutions. In the interests of providing a contrasting point of view, I want to point out that Kevin Drum thinks that small banks can do just as much damage as big banks:

I think crude bank size is a red herring for our current financial collapse.  Small banks can become overleveraged just as easily as big ones, hedge funds pay higher salaries than Wall Street behemoths, the interconnectedness of the global financial sector is a bigger cause of systemic worries than size alone, and credit expansions spiral out of control largely due to lack of political will, not because Citigroup is large and clumsy.  Those are the things we should be focused on.

Therefore, Drum favors systemic oversight and regulation (which I agree would also be good). Besides the first article cited above, he continues the argument here.

38 responses to “Does Size Matter?

  1. It’s clear, matematically, that if you put in a raw 10000 soldiers, you could call it an army, more or less Pancho Villa style.

    In the same way, 100 gamblers playing together with someone else’s money with a couple of martinis in Las Vegas could wipe out the Nevada state monies in just one night.

    What the f***k are serious economists talking about this sort of stupid things?


    Let put one hundred if-s before one item, and once the all, one after the other, get fulfilled… would you the blame in the item or in the if-puters?

    Stop pissing off, please.

    Economy is not so hard a science as far as you don’t lose your common sense. Don’t try to make abstract concepts with massive brain stupid conclusions, to talk about big or small. In economics or physics it’s all the same.

    “Too big to fall”: The banks has more liabilities that the government.


    I’d like to see an economist arguing with their husband/wife talking about “size matters”, the rest of the world would be asking they were referring to the wallet, the brain or the cock? Would anyone think about the economy?

    Sorry the tone, but don’t lose your roots.


  2. main correction:

    “Too big to fall”: The banks has more liabilities than government’s money.

  3. Talking in other words, one nuke is enough to blow up Manhattan?

    Of course it is.

    So, what’s the matter about one nuke or three nukes, a big one or a small one?

    What we are talking is about if government have to bail out gamblers or not? Not less nor more.

    So you have to define what’s a gambler and what’s a bank, and draw a clear line in between: Glass-Steagall Act, more or less reinvented for internet age.

    The size is the last invention to take over the government and the economy.

    But even in this case, a leveraged player with lots of luck could brake the bank.

    Who set the rules? The government or the gamblers? That was the main question of The Atlantic article. Nothing else. If the oligarchs win, as I’m afraid of, Obama is toast.

    It’s getting to deserve to be toast, but James & Co, I take off my hat because some people starts to speak their mind.

    Good evening!

  4. Seems like common sense: the bigger the bank the more goes down with it. So size does matter, no?

  5. @Frank,

    I think interdependency can create a negative network effect, or “reverse bandwagon” which exhibits damaging phenomena both temporally and on large scales. If true, as Drum argues, whether there’s one big bank or a tightly coupled set of thousand smaller ones, although Drum doesn’t say anything about network effects.

    At the very least, an economy which benefitted from positive network effects might suffer severely if, because of fear of risk, these effects suddenly end, because every node wants to decouple from the rest of their neighbors. That sounds like an insignificant decision, but to the degree the interconnectedness produced real GDP, it’s a loss.

  6. Anyway, be careful, some people are already talking about Social Security and Medicare to toast Obama.

  7. 1 currency now

    I like the 2-tier approach advocated by Volcker: one with tight regulation of day-to-day commercial banking, another very loose for high rollers.

    In most ski country states, if you stay within the boundaries you may rely a level of rescue and care of the trails, notice of dangerous conditions, etc.

    Off-piste out of bounds is more exciting, and no longer prohibited as it used to be, but you assume the risk. In some places they can recoup (clawback) the cost of a rescue if you’re lost or injured.

  8. Interesting analogy – but one can easily imagine a scenario where (due to leverage) the cost of rescue is so large that it cannot be clawed back, and the damage to the economy is so profound that a rescue must occur.

    While it’s hard to argue against “size matters”, one has to wonder “how much?” Reducing the size of individual institutions, alone, is not as important as reducing the size of the entire banking sector and regulating it more effectively. And that can only be accomplished by reducing the amount of debt (moving more toward a currency-based economy). And that requires deleveraging along with replacement of debt with currency (which means leverage levels must be reduced, and cash must be pumped back into the economy).

    Remember, we had small banks in the Great Depression, and thousands failed – with consequences.

    It seems, unfortunately, that the method of pushing cash into the economy to replace credit involves a little bit of stimulus and a lot of giveaways to banks (that don’t look like giveaways).

    OH, and all this after scaring the wits out of common citizens, so that they have essentially capitulated… “Better this than nothing!”

    I happen to agree “Better this than nothing”… Doing nothing is really bad. Awful beyond measure.

    However, the choice (for Team Obama) was _not_ doing this or nothing. That is the choice they are giving us (and our incompetent Congress), but not the choice they had when crafting the plan.

    It is VERY important that commentors continue to remind the public of this. There were _many_ other plans out there. (FDIC receivorship was only one of those plans.)

    The general attitude (among less sophisticated observers) is that at least the govt. did something and it appears to be working. Rather than insisting it will fail (it might or might not – even the pros disagree), we may want to make the case that other ideas would have worked just as well – without rewarding banks.

  9. In psychology there seems to be an understanding that people prefer to have control, no matter how irrational and ridiculous a belief may be, the feeling of control if important to hold the mind together–so if we blame ourselves for someone’s death, when rationally nothing we could have done would have helped, this self-blame is preferred to the infinitely more hurtful feeling of helplessness.

    This psychology was used skillfully in the fall–when people were told that “the world would end as we know it” by the bank cartel, we the people lost our ability to reason…if we could have reasoned we would have been saying “good” this needs to end, let the smaller banks that aren’t involved in the cartel buy for pennies on the dollar the useful assets of the corrupt entities and lets use the governments balance sheet to help bet by in this difficult time–

    instead, the word ‘nationalism” became the F word too terrible to discuss which added to the power of opening up the doors of our children’s future and saying to the bank cartel, “here, take it all” When we failed at that time, we also failed in the eyes of the world…the world was hoping for Obama to save us from this crime, but he looks like he is only a puppet to the bank cartel now…so the world is viewing us as corrupt….i personally want our country to ask for it’s integrity back, and that won’t happen until the crime is prosecuted…if it goes unprosecuted, it makes us, all us citizens guilty.

  10. If only small, non-trust banks existed, would they be able to become so overleveraged in such a way that the failure of any one could trigger systemic failure?

    At any rate, I don’t see why there has to be an argument. It seems clear we need both to cap size as such but as well as eradicate casino-type behavior.

  11. Dear Mr Kwak … This is a way off your subject and not suitable for posting, but I am convinced size matters generally and found both your paper and Johnson’s Atlantic article to be very persuasive with respect to financial instutions. I am a retired civil servant with over 30 years experience in the Department of Defense and I grappled with our version of the problems you are dealing with. Attached for your information is a copy of an email I sent to my list pointing out similarities between problems of the two economic sectors.

    Versailles on the Potomac Meets Versailles on the Hudson … and
    … Finds They Share the Same Social DNA.

    Chuck Spinney
    March 29, 2009

    Over the course of my 33 year career in the Defense Department, first as an Air Force officer, then as a civilian, the central thrust my efforts evolved without design into a focus aimed at understanding why the Pentagon bureaucracy, the American military, the Congress, and the defense industry (i.e. the military-industrial-congressional complex or MICC)  could not, and indeed would not, adapt to changing conditions in order to extricate itself from what was clearly an ever more expensive death spiral of shrinking forces, aging weapons, continual pressure to reduce its readiness fight, should a war.  I came to appreciate some general qualities are intrinsically associated with this intractable and ultimately self-destructive non-adaptive behavior.  

    The qualities impeding the decision-making  system from making a rational adaptation to a clearly visible system of dysfunctional behavior included. 

    • The intimidating effects of increasing complexity (in terms of technological, conceptual, organizational, managerial, and political complexities)  Complexity being defined as a quality of the “whole” that relates the number and arrangements of the “parts” to one’s ability to understand the “whole.”  It follows, therefore, that increasing complexity runs up the number of parts and multiplies the variety of arrangements among those parts.  This naturally decreases one’s ability to comprehend the whole.  The increased difficulty of comprehension makes it more difficult to understand and identify what corrective measures are really needed and more difficult to reorient the whole by changing the larger number and rearranging the greater variety of connections among the parts in a way that brings about the coherent adaptation to the problem. Viewed this way, a status quo devoted to increasing complexity can use that complexity to protect itself from change. 

    • Increasing giantism that leads to an implicit condition of being too big to fail.  This also thwarts the impulse to change.  It is difficult to terminate humongous weapon systems like the F-22 or missile defense system when the dollars and jobs are flowing to hundreds of congressional districts usually spead throughout 40+ states. On the other hand, it is much easier to terminate production of a simpler system with a much smaller political support network.  Increasing giantism is also reflected in increasing concentration in the industrial base into a smaller number of bigger industrial contractors who wield more political power.

    • Increasing politicization — e.g, a hall of mirrors built by deceptive bureaucratic gaming practices, like those explained here. Politicization is also sustained and increased by the ease with which high and mid-level managers and military officer move back and forth through the revolving door between government and the defense contractors in the government-subsidized private sector.

    • Crony capitalism — or the condition where government-industry partnerships put industry interests ahead of public interests. As Eisenhower said in his farewell address, “… the danger of misplaced power exists and will persist.”

    • And perhaps most importantly, the existence of mind-numbing belief systems that have evolved to justify the current course of action, even in the presence of evidence to the contrary — e.g. the ubiquitous ideology that emerging technological advances will remove the fog and friction of war and thereby reduce the conduct of war to the equivalent of an engineering problem.

    Now with the Pentagon’s self-destructive qualities in mind, read Simon Johnson’s essay in the current issue of the Atlantic, attached below. He explains why President Obama’s financial rescue plan is unlikely to change the self-destructive behaviour that has wrecked the financial sector of the American economy and possibly the whole American economy, to boot.  Johnson, a former chief economist of the International Monetary Fund, is an insider’s insider on the subject of financial rescue packages.  He is also one of the founding members of a most informative website, The Baseline Scenario, which is designed to explain the causes of the current financial crisis in terms that are intelligible to the educated layman (i.e., he is trying to reduce the complexity of a deliberately complexified problem to make it easier for the average schmuck to understand it — something the oligarchs on Wall Street would prefer not happen).  

    While the scale of venality of Wall Steet dwarfs that of the Pentagon’s, I submit that many of the central qualities shaping America’s Defense Meltdown (an important new book with this title, also written by insiders,  can be found here) can be found in Simon Johnson’s exegesis of America’s even more profound Financial Meltdown.  Both are products of an elite that leaches off the masses without feeling any reciprocal obligation to protect their welfare.  And that is why Versailles on the Potomac and Versailles on Hudson are reflections of a deeper moral decadence that would would be perfectly at home in the court of Louis XVI.

    Chuck Spinney
    Marmaris, Turkey

  12. some guy in a cube

    Chuck Spinney wrote: “Both are products of an elite that leaches off the masses without feeling any reciprocal obligation to protect their welfare. ”

    Yes, exactly! I lay the blame for this crisis on the character (or complete lack thereof) of this generation of elites.

    By example, our grandfathers set up pensions for their employees, today’s elite wants to tear-down H1-B so that workers can be imported into an economy that is destroying jobs, or destroy social security in the name of “fiscal responsibility”

    It’s enough to make a decent man’s skin crawl.

  13. thank you Anonymous!

  14. Under Big and Small, Ed posited that the process isn’t random. It is to some extent. Consider that there are 5,000-odd FDIC insured banks. Currently, about 250 are on a watch list and 100-odd have failed. If the process weren’t random, all 5,000 would become insolvent on the same day. Maybe there are not enough FDIC personnel to make this happen. More likely, there is enough variability in bank assets so that impairment varies from bank to bank. The global economic environment is the same for each, but some banks are concentrated in regions with variations. Bank officers react differently and use different strategies. Thus, in spite of the availability of various instruments, the risk has not been spread 100% evenly. The net result is that, so far, the number and speed of failures is small, at least based on numbers of banks.

    Suppose the top 20 banks, with about half of banking assets, were broken into 5000 little banks. Then, there would be another 250 on watch list. Probably, this is still manageable.

    Still, will big banks make us rich? They could do this in two ways. US multinationals, like IBM, may need big banks to operate. Since IBM repatriates profits to American stockholders, big banks may be useful. Second, big banks may themselves generate profits outside the US which are repatriated. As to the first, one would have to ask IBM, Boeing, Caterpillar, etc. As to the second, the image of large American banks is so tarnished that attracting foreign clients may prove difficult for some time.

  15. I agree that size is a red herring. The crux of this situation is that banking regulations did not keep pace with financial innovation.

    One could argue that this happened because there was not the political will to tighten banking standards and that the absence of political will is due to banks increasing in size and political power. But smaller organizations form politically powerful industry groups all the time.

    In my opinion, the only thing that would prevent this event from happening again would be if people were not completely sheltered by the government from experiencing the consequences of their actions this time around.

  16. Size matters: 1 dollar equals 1 “vote”!

    Technocrats should pause in their discussion of the optimal size of banks, how restrictive “regulation” should be, and whether TARP, TALF, etc. are, or are not “working”. There is a bigger issue that needs everyone’s full attention.

    This “financial” crisis is about the political power of a world banking oligarchy: the big banks, the central banks (an extension of the big banks, disguised as independent government agencies), the government banking officials (like Geithner, Summers, Volcker et al) and lobbyists who direct untold financial industry dollars at the people’s “representatives” to make sure the oligarchy maintains power.

    This is not a conspiracy: it’s simply those with power acting in their “enlightened” self-interest.

    Unless and until the political power of the banking oligarchy is greatly reduced (dare one hope eliminated?), we will only experience temporary and local improvements (if any) to the real economy. What’s more, these “improvements” will only be the by-products of actions taken by the oligarchy to reinforce its power over the rest of us.

    Simon, James, and other much more knowledgeable commentators than I, have alluded to these facts, or made similar observations, but they are always very muted, and seem deferential to either the oligarchy itself, or to those who would prefer to debate the technical details forever.

    This crisis is about who rules.

  17. Of course power struggles have much to do with this crisis, but I think that framing the issues only in terms powerful bankers versus powerless people is unhelpful.

    The glory of this blog and its comments is that it has hosted a frank exchange of diverse views without descending too often to party-political posturing or speaking-truth-to-power paranoia.

    Rather its thrust seems to be “making sense together”. I congratulate Simon, MIT and its leadership on this valuable discourse.

  18. Bill Bradbrooke

    Here, here!

  19. I didn’t say that the people were “powerless.’ But I would like to see the current distribution of political power modified to give the banking/finance interests much less, and restore power to democratic institutions and processes.

    For you to describe my sincerely held opinion that an oligarchy of bankers exercise far too much power as “speaking-truth-to-power paranoia” does not (to my way of thinking) illustrate the “glory of this blog” or a “frank exchange of diverse views without descending, etc “.

    I may be mistaken in my view, but I find the refusal to seriously address its possibility in blogs like this one is to use your word “unhelpful.” Extensive discussion of the technical and policy alternatives should be more than balanced by closer scrutiny of who is exercising real power and in whose interests.

  20. I’d really like to see the “small” bank idea fleshed out more. What is the threshold where a bank is too large? If the US financial system were reduced to a network of small banks, what would this do to international commerce and the US economy?

    Wouldn’t you be placing a cap on how large all US corporations can get? Microsoft can’t exactly get a liquidity facility from the local credit union. It would take an army of small banks to market California’s recent $6.5 billion bond deal.

  21. Such offerings are usually handled by syndicates. For example, California is offering $4B in general obligation bonds on April 1, 2009 with lead underwriters Merrill Lynch and Citi, but with 37 others. Does it take the size of Merrill and Cit to arrange such a syndicate? I could be mistaken, but I think not.

  22. Yes, syndicates are often involved in new bond issues, but the syndicate is typically managed by a very large bank and the distribution of risk varies. There is no way in the world a small bank could run a deal like that.

    Our financial world is big. If you look at things from the standpoint of the individual consumer/household, this might seem like a wonderfully elegant solution to this mess. But if you look at it from an institutional standpoint, there are many things smaller banks cannot handle.

    Even from a consumer standpoint, however, most of what you receive from a “small” bank are big bank products with a small bank brand.

  23. Bill Bradbrooke


    In Big and Small you say:

    “…First, you have to expect that no matter how clever your regulatory scheme, some firms will be even more clever in finding ways to evade the system and blow themselves up. You are far better off if they are small when they blow up than if they are big….”

    I don’t disagree and I don’t want to pick nits, but if “…some firms will be more clever in finding ways to evade the system…”, then doesn’t your premise deny your conclusion (so to speak)? If a firm successfully evades the system it becomes bigger than your regulatory limit allows and who’s to say that it hasn’t already become “too big to fail” at the time it’s transgression is discovered?

    In fact, didn’t something like this happen in the case of AIG? Its life and casualty business was well secured, however, AIG FP managed to qualify itself for regulation by the least sophisticated regulatory agency (an agency currently under investigation). It then convinced the top regulators in the land, Fed Chairman, Greenspan, Treasury Secretary, Rubin, and Bill Clinton, then President, to endorse legislation to the effect that the product Warren Buffet has referred to as a “financial weapon of mass destruction” would be untroubled by securities regulators, insurance regulators or gambling regulators. As I recall, and please correct me if I’m wrong, there was significant opposition to the legislation and someone at the SEC lost his job for taking an opposing view.

    Size is irrelevant. If leverage and the quality of security are under control that is all that is important. Is anyone screaming for limiting the size of Canadian banks?

  24. I think that not all regulations are equally easy to evade. Other things being equal, I suspect that the simpler the regulation, the harder it is to evade. A cap on institutions by assets seems pretty simple and hence pretty hard to evade. That’s the hope, at least.

    There are two lessons of AIG. One is that powerful lobby groups (the International Swaps and Derivatives Association, in this case), can get the regulation they want. The second is that powerful institutions (AIG, in this case) can exploit regulatory loopholes. Again, I think the lesson is you need simpler regulation (fewer loopholes) and less-powerful institutions.

  25. Bill Bradbrooke

    I appreciate what you are saying, a cap on assets is a simple regulation to enforce. I agree, but I do not see the relevance. Our problem is systemic, that is, it affects our entire financial system. It matters not whether that system comprises a small number of large institutions or a large number of small institutions. They hold the same assets and those assets are flawed. If they weren’t flawed we wouldn’t be in trouble. As I see it, the fewer the number of institutions in the system, the easier it would be to deal with a systemic problem.

    The influence of lobbies wouldn’t be affected by capping the size of financial institutions. The point of lobbies is to gather the many into one. And, did AIG use its size to exploit regulatory loopholes or did simply buy a savings and loan and thereby pass itself off as something small, innocuous and unthreatening.

    I concede AIG did not actively prevent the impression that it was a large, powerful, AAA rated company from informing the marketing of its derivatives. But that has to do with marketing ethics and the quality of the products themselves.

    I don’t know, James; I just don’t see it. I think containing leverage is far more important than capping assets, and of greatest importance is a thorough understanding of the financial product itself and its quality relative to other products.

  26. Size matters – obviously. Look at how US policy selectively differs toward various institutions.

    The other issue is control of ‘systemic’ risk: this is quite impossible as long as the government is part of the system. Regulation won’t do the job when the regulators are bought, either directly or through promise of future jobs or through membership in a sort of social ‘club’.

    Some really drastic change and reform is needed and I think the scope of this is way beyond anything this administration has in mind. If it cannot step up to the job it will eventually go down in flames, and maybe the next administration will be forced to do it.

  27. James,

    I think you are drastically overestimating the market price from Drum insights, and underestimate the market price for your own. It sounds like Drum doesn’t understand the connection between size and lobbying, and that you are already forgetting it? Or put simpler, if a small bank is leveraged to hell it is no longer a small bank. If it still a small bank, than maybe a 50:1 leverage on pennies is not systemic risk.

  28. Thanks. I’m not agreeing with Drum – I just felt the need to point to a contrasting view.

  29. For obvious reason, some commentators have hijacked the process of analyzing the root cause of the current crisis to get to their pet peeve. The crisis, first and foremost, was the result of monumentally wrong policy judgements — using US consumption and the consequent debt growth to ward off the negative wealth effect of the busting of an equity bubble — compounded by blind mercantilist policies of Asia’s net exporters — unprecendented reserve building after the Asian crisis (and following the IMF advice a bit too closely, in fact). Clearly, growth of the financial sector and bankers’ pay was the consequence of these bad judgements on the part of policy makers and foreign politicians, rather than the root cause of all evil in the world. In the current political environment, if you repeat the base assertion frequently enough — as you and others have been doing — it will of course stick. But that does not make it the correct root cause analysis. Banks and bankers are easy targets right now but focusing on them exclusively will not fix the global order — doing something about reducing consumption and increasing savings in the US (perhaps not in the near term but definitely in the medium to long term) and increasing consumption and reducing currency subsidised exports in the developing world will go a long away. You should be focusing on those issues rather than take easy shots at banks and bankers. That’s like trying to solve the drug problem by arresting the street drug peddlers.

  30. 1 currency now

    To expand on the ski analogy, a large and obnoxious but powerful group has recklessly ventured off-piste, bringing snowmobiles and ignoring safety. They have set off an avalanche burying all the careful skiers and the town below.

    There are not enough resources to save everyone. So it’s triage, saving the town first, then the careful skiers.

    The two-tier approach starts in the rebuilding, and the reckless are not allowed to go in large groups, use inappropriate vehicles, etc.

  31. please take a look at

  32. Very sexy title James!

    Bottom line, dancing in circles solves no problem except the problem of can we dance in circles?

    Here is a list that can help to solving some of what ails our country:

    1) Our president needs to publicly admit that the bank policies started in the fall are wrong, and that until further notice, all public/private partnerships need to stop–

    a) and that there will be a public investigation on the actions taken in the fall by the joint decision of the fed and the treasury ranging from stalling on letting lehman brothers have bank holding status and denying them from a 6 billion dollar bridge loan, to all the public statements that were made which in effect acted like a lobby for TARP 1 and all of the trillions of dollars given to already insolvent institutions.

    b) Retroactive accounting to which TARP 1 recipients were failed prior to Lehman publicly failing, and for those institutions that were buffered by the failing of Lehman, and subsequent free money through AIG, they need to pay all bank loans, and backstops immediately or withing 30 days (and the president needs to gat a law passed that could do this ) And any banks, bank hodling companies that cannot manage to do this will be taken into receivership.

    c) Since the basis of the approach to “save the world” was flawed, there will be many complaits that will need to sorted out, and in time this will be done in time. But for now, the top priortity is to correct the damage of what has been done, and hold accountable the makers of this flawed approach which, unless unwound, is holding our children’s future hostage.


    This time in our history will be called THE AGE OF REDHERRINGS used to RAPE AND PILLAGE THE FUTURE OF AMERICA”

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  35. Hi, I haven’t read your pieces yet, and Drum’s, so this is an off-the-cuff response. “Too small to succeed” may be just as bad as “too big to fail.” Pooling and allocating quickly large sums of capital strikes me as a desirable goal, which suggests an advantage for large banks. Obviously this magnifies the consequences of their actions for both good and ill, but I don’t have an instinctive “small is beautiful” response to this crisis.

    The appropriate size is at least partly an empirical question. It would be good to look at the literature on relationship between bank size and performance, though it’s not obvious to me what the right metrics for evaluating performance would be. Perhaps they should be different for different banking functions. But in light of recent events, some measure of solvency is surely necessary.

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  37. wouldn’t capitalism function much better (and more efficiently) if no entity were “too big to fail”?

    (the possible exception would be a sovereign state)