Guest Post: Size Really Does Matter

This guest post was contributed by Lawrence Baxter, a member of the faculty at Duke Law School and formerly a divisional executive in a large banking organization. He takes a look inside the large mergers that created the behemoth financial institutions we know today, and the assumptions that encouraged and allowed those mergers.

A friend recently observed to me that he had maintained zero interest in banks and banking all his life—until the past year.  Now everyone is engaged in a swirl of emotions and punditry as we focus as experts, taxpayers or consumers on almost every dimension of the financial crisis, from bailouts to complex executive compensation schemes.  Yet throughout the commotion we have not lost our faith in one quintessential American value:  bigger is better.  How quickly we forget such disasters as Daimler Chrysler and Travelers-Citicorp, even as we hail Chrysler-Fiat.

True, a consequence of great scale has informed the public policy debate on banks:  what do we do with a financial institutions that is “too big to fail”?  Yet answers to this question have, for the most part, turned on whether a particular company should be allowed to fail, or be propped up by government action.  The underlying pathology receives only passing attention.   Why do we let these institutions get so large in the first place?  Is it not likely that many of the institutions requiring massive injections of public capital and other forms of subsidization and public assistance are, and have been for some time, simply too big to manage?

America’s obsession with bigness has led us to assume glibly that organizational growth, vertical and lateral, is a natural consequence of business success and must be respected, even celebrated.  Armies of consultants, lawyers and investment bankers devote their businesses to the science of corporate enlargement, encouraged by economists who celebrate not only economies of scale, but even “economies of super scale.”  Ken Thompson, then CEO of one of the most venerated banks in the United States, Wachovia, spoke for an industry when he declared in 2006, at the very moment the company was making its fatal acquisition of Golden West Financial, that ““[c]onsolidation continues to make economic sense.  Done right, size enhances competitive power.  With economies of scale, a company can better afford the technology and longer branch hours that customers demand.”*

Mr. Thompson was not saying anything controversial.  His own company had enjoyed years of success in the wake of several large acquisitions and scores of smaller ones.  The entire industry was reveling in size.  Regulators, from the Fed to the Justice Department, were approving almost every M&A in sight.  The stock market was on a veritable sugar high after the brief setback of 2001 and 2002.  A college of academic theorists was urging US adoption of the universal bank idea.  Great engines of technology seemed capable of automating almost anything, from back office processing to customer relationship management.  Large-scale offshoring offered enticing opportunities for global labor arbitrage.  The nirvana of rising revenue and declining costs seemed tantalizingly close to reach.  Who could object to rewarding handsomely the corporate superstars who were making this exquisite success possible?  Few questioned whether the logic of financial consolidation actually made sense, even as ominous clouds gathered on the horizon.  In its 2009 outlook The Economist accepted, albeit gloomily, that “Western finance will be increasingly dominated by a few huge universal banks, with a new aversion to risk”—as if such institutions could, let alone would, actually be able to avert risk.

America’s financial institutions grew at brisk pace once the first spigots of deregulation began to open in 1980.  Consolidation not only aggregated assets and capital at stupendous rates; it also meant that the people and systems of each of these organizations had been ramped from relatively small operations into gargantuan ones that many bank employees had never dreamed of.  Many a small town banker suddenly found himself at the helm of a business line or operating unit far larger—sometimes four or five times larger—than had been those of the great major money center banks of 1980.  And many a customer experienced an involuntary re-introduction to a rapidly growing bank that hardly knew them anymore.  Bits and pieces that did not fit the vision were sold off into an even further removed world of outsourced services.

Nor did these big new adventures feel all that scary.  For those in control, compensation escalated to match the bold new responsibilities such executives had now acquired.  The word “leadership” was substituted for “management” as the new corporate big leaguers learned the art of articulating grand vision while delegating detail.  A reassuring chorus of supporting consultants produced reams of PowerPoint highlighting challenges and providing scientific graphs and charts filled with solutions.  Boards enjoyed their exciting Sunday meetings to approve new deals that would enhance prestige and stun Monday morning markets.  Beamingly confident CEOs assured credulous investment analysts and reporters that their big new adventures would render amazing efficiencies by exploiting technological scale, juicy new customer bases in “fast growth regions,” and cost redundancies (i.e. employees).  Brand experts eagerly made travel reservations from Madison Avenue to victorious headquarters where they would compete breathlessly for assignments that would anoint new companies with visionary logos and stunning customer value propositions.

Meanwhile, back at the office, the games would begin.  Systems would be identified for selection or elimination—a magical opportunity to take the best of each world.  Employees, locations, operations and lines of business would be analyzed to ensure that overlaps would be eliminated and customers served better than ever.  HR consultants would be brought in to hasten the adoption by employees of new cultures.  Generous severance packages and retention bonuses—all surely offset in their expense by the seductive efficiencies of the merger—would be secretly prepared and offered to surplus employees.  This was American bio-corporatism at its finest.

Where were the regulators?  We talk of deregulation as if this was a phenomenon introduced by the Bush Administration in 2002.  Yet the deregulation movement had been building for twenty years or more on many fronts.  In the financial world it was represented by a number of iconic developments, beginning with the deregulation of interest rates in 1980 and accelerating with the demise of restrictions on geographic expansion by banks (1979–1994), the repeal of the Glass-Steagall Act (which tried to separate commerce and banking, and investment and commercial banking) in 1999, and the emergence of a gigantic “shadow financial system” that cast itself well beyond the traditional balance sheets of banks.  Potentially tough regulation developed in the wake of the S&L Crisis with legislation in 1989 and 1992 was itself offset by a growing deregulatory philosophy based on deep faith in the discipline of market mechanisms.  The federal deposit insurance funds were so flush in the absence of bank failures and the rapid growth of assessable deposits that banks were relieved of the need to pay insurance assessments altogether.

And the truth is that much of the modernization was needed.  The rickety structure of bank regulation in America was not only odd by comparison to some foreign competitors, but the system of “non-bank” finance companies, securities and insurance companies purveying credit and other “bank-like” products had reached a scale that all but rendered the traditional framework of banking regulation a farce.  It is hard to gainsay the wisdom of many actions taken by the deregulators, at least as far as well established and well understood financial products were concerned, and at least as far as deregulation sought to break down the very real barriers to competition that genuinely archaic restrictions provided.

The net effect of all of this progress was a rapid expansion in the scope of “banking” activity and a remorseless expansion in size of the players engaged in such activity.  All the while it was also largely assumed that the large-scale management of such financial activities was itself not a problem.  Far from creating the potential for concern, bigger had to be better, particularly if such non-American behemoths as HSBC, Deutsche, ING, and others were dwarfing our own.  American bank consolidation became a veritable patriotic duty and a merger spree began. 

Sadly, a lot of things happen inside mergers that no one likes to talk about.

First, the best technology systems are not always chosen.  Far from it.  Unless the larger partner to a merger is at the point of collapse, an inevitable dynamic in most mergers is that the larger company wins.  Even where it is recognized that the smaller company has better technology (as is often the case because the larger company tends to have older systems), the possibility of damage to the larger customer base during system and database conversions leads risk-averse IT executives to choose the inferior systems.  Intense management might sometimes produce acceptable results, but usually it will be years before problems created by a downgrade to inferior systems can be fixed.  The connection between the original merger and later, consequential expense is therefore hard to discern.

Another thing that happens is that a lot of expertise gets thrown out the door.  Industrial researchers have warned of the damaging loss of intellectual capital resulting from the recent trend to earlier retirement.  Add to this the sheer intellectual devastation wrought by the elimination of hundreds of thousands of longtime financial employees, conveniently dismissed as “redundancies” (or, more quietly by the survivors, as corporate “deadwood”).  This loss of institutional memory and knowledge is an important yet hidden cost of many mergers, in which the elimination of real people is treated for investment purposes as an elimination of “headcount” expense.

Then there is the awkward problem of culture.  Anyone who has worked in a genuinely high performance culture (and not just one like Lake Wobegone whose children are “all above average”) will know that people provide much more value to an organization when they are motivated and develop effective relationships within and beyond the organization.  Motivation itself comes from various sources, including raw compensation, but one of the sources large entities rely upon more than they even recognize is a culture of performance, itself generated by a sense of shared commitment.  Walk into and Apple store if you aren’t following me. 

The reality, however, is that it takes a long time to evolve a culture.  Trust is the bedrock of culture and trust is earned through repeat engagement.  Once a culture emerges, all kinds of “efficiencies” start to occur.  Employee interactions become efficient ongoing relationships.  Insecurities recede and so does destructive territoriality.  People start to cooperate with each other.  With such cultures some companies have proven that they can become genuinely high performing, outstripping competitors and adding real shareholder value.

Alas not so for rapid mergers.  Employees caught up in merger situations often tend to become deeply suspicious of their new associates.  Territoriality escalates, driven by a justified belief that this is necessary for survival.  Employees start to under-perform or, sometimes, even to act directly contrary to the interests of the new combination.  Reliable information about what is actually happening becomes increasingly difficult to uncover, even for the most assiduous of managers.

A very salient aspect of the Financial Crisis is the failure of risk management.  Not only do risk managers appear to have been asleep at the switch in many instances.  It is also evident that even when they were aggressively trying to manage risk they did not know what they were managing.  Scientists of risk management have explanations for why this has been the case.  Whatever the theoretical explanations, there is also one very simple but frequently overlooked additional element:  our faith in technology has lulled us into believing that highly diverse metrics could be correlated if only good systems are in place. 

Yet systems, no matter how good they might be in conception and even implementation, are merely engines that convert input into output.  If people load garbage in, garbage always comes out.  This is not because those who provide input are dishonest:  in complex environments such as those created by “efficiencies of scale and scope” (i.e. rapid combinations of lines of business with clashing cultures and denuded of the institutional memory of recently laid off employees and relying on patchwork quilts of uneven technology) the providers of input, no matter how diligent, cannot properly understand what it is they are being asked to put into the pipeline. 

For technologically illiterate executives, bored by risk management at best and frustrated by its necessary impediment to revenue generation at worst, complex systems render an illusion of control.  “Dashboards” coded in red, yellow and green suggest that scientific management is afoot, that IT systems have worked their wonders in processing right data.  The output presents a familiar, manageable set of executive decision points.  Perplexed regulators feel reassured that the organization has a handle on things—after all, the company has put so much effort into developing a scientific system for measuring and managing its risk.

What does this mean for public policy?

At the very least we ought to re-examine our assumptions about letting banks, or any financial institution the actions of which generate systemic concerns, grow to whatever size they desire.  Antitrust analysis has taken a back seat to “market discipline.”  Yet it is not at all clear that markets have the information or power necessary to ensure that the discipline of the market will prevent the growth of institutions that are too big to handle.  Optimal size assumptions, ones that do not rely upon surreptitiously externalized or postponed risk and costs, ought to be an important yardstick in antitrust analysis.

Secondly, we should not assume that corporations are internally coherent.  Employees operate in large divisions, frequently strangers to each other; sometimes they even have to operate in environments fragmented by cultural misalignment and division.  Incentive structures are widely different and do not necessarily ensure that everyone acts for the good of the shareholder.  Conflicts of interest remain even after complex formal controls are imposed—indeed these controls often create more opportunities than ever for inimical arbitrage within the organization.  It is quite possible that something like the re-imposition of some Glass-Steagall type constraints is needed to prevent unnatural combinations and impose structural curbs on the risk-taking that has created the present crisis.

Third, when corporate executives claim that they can live large safely, directors, shareholders, analysts and reporters should apply healthy doses of skepticism.  It would be more effective to require executives to account, without excuses, for their success in actually delivering and preserving what they already promised the last time than to accept promises of future performance.

America has always celebrated competition.  Our recent experience suggests that our obsession with size has diverted the focus from this critical element of our economic strength and it is high time to question whether it is how corporations can really perform, not how big they can get, that should be the foundation for sound merger and acquisition policy.

* “Wachovia Chief’s Vision:  A Handful of Dominant Firms,” interview with Barbara A. Rehm, American Banker, May 19 2006.

42 responses to “Guest Post: Size Really Does Matter

  1. Not a bad article, but much of it talks about the disadvantages of mergers in general, which is not specific to the finance industry. If a merger is actually bad for a company, the market should correct it eventually with the corporation failing.

    The problem is specific to companies that are “too big to fail”, which is what we have with financial firms. The solution, as pointed out on this site and elsewhere, is actually pretty simple: Pass new laws recognizing that “Too big to fail is too big to exist.”

  2. Too Big To Fail is simply the most overtly extortionist manifestation of the intrinsic bullying nature of size in itself.

    Just as power corrupts, and absolute power corrupts absolutely, so size necessarily gets away from real competitiveness, real innovation, real talent-empowering, and goes in for the rent-seeking corporatist “truthiness” versions of these things: the ideologically branded simulacra of “innovation” and “talent”, which now simply measure one’s prowess as a trustifier, lobbyist, glad-hander, back-slapper, con man.

    Size seems to intrinsically go through this metamorphosis, and tremendous size does so tremendously. Contrary to the lies of the rhetoric quoted above, concentration and consolidation and centralization are on their face anti-competitive and anti-freedom.

    Nothing ever became so big through some benevolent market allocation logic. Proportional to its size it also engaged in anti-competitive and anti-labor practices, lobbying, capturing regulators and legislators, having anti-social laws written to replace those favorable to the public interest, and generally sought to hollow out and destroy all public space and real productive activity (since any real economic activity is always a threat to entrenched feudalism).

    Size and only size enables this. It is a clear and present danger to the public interest and the national interest. It can only ever empower the most vicious, gutter sort of greed.

    As Shakespeare has Ulysses put it, without degree,

    Then everything includes itself in power,
    Power into will, will into appetite;
    An appetite, an universal wolf,
    Must make perforce an universal prey,
    And last eat up itself.

    As we see today.

  3. tomaso spingardi

    “Too big too fail”: our current nightmare, a monster a number of us have contributed in building. I am Tomaso Spingardi, I spent some 20 years in investment banking, advising mainly financial institutions on mergers and acquisitions. The advantage of a larger size on ROE, broad based risk metrics, performance criteria, strategic competitive sustainable positioning and value creation was always almost too easy to demonstrate.

    Currently we face the dilemma of playing between the two extremes: regulations, widely known for being late and inadequate. and deregulation, equally known for its disastrous effects.

    I tend to subscribe to the view, as written in several articles and seminars, that we do need a new type of regulator, market based, forward looking and better equipped in terms of technology and global presence in order to face the challenge of monitoring global players.

    as always, the devil is in the implementation.

    Tomaso Spingardi

  4. John Durham

    “The Market is not “self-regulating” at all and never has been nor has anyone actually proven that it is. It is a dogma of long standing with few presidential detractors other than Washington-Hamilton, Lincoln & FDR. What the market is able to do in a free country is ADJUST to changing conditions. Therefore, it is for the Constitution, government and the people to REGULATE. It is there after for the market to adjust itself, the which it will do always.

  5. annie simon

    typo, fyi — “too big (to) manage” in first part of article

  6. slightly off topic, but if this argument “too big to fail, too big to exist” is accepted, then could a parallel argument be made for supporting trade barriers? i think the constant promotion of free trade would eventually lead to division of labor on a grander scale (probably has already). what would happen one day if the countries that supply goods and services to the u.s. just stopped? i currently reside in panama and had a good discussion with my business partner, who is colombian. he described how colombia was sealed off to the world and that forced it to be self-sufficient. i argued against his belief, however, having seen the situation with banks, maybe have some friction is good.

  7. Interesting perspective on the optimal scale debate.

    The question of optimal institutional size hinges on where to draw the line between vertically integrated transactions (“firms”, which operate using authority) and horizontally negotiated transactions (“market”, which operate using specified contracts).

    For example, should we require more vertical integration of loan servicing and financing? Maybe that’s a good idea – it avoids some information asymmetries between loan sellers/buyers, and reduces transaction costs associated with loan restructuring should that be become necessary.

    But wait! Baxter warns us that we should not automatically assume that banks will function better just because the servicing and financing functions are housed under the same roof! We forgot the Dilbert Factor. Yah, the two divisions are under the same roof, but they’re… well, divided into divisions. Each with its own incentive structure, leaders, culture, etc.

    Certainly worth chewing on. I would posit that the answer probably involves a distribution of bank sizes – and the market was already there a few decades ago. But the market doesn’t stay still. Any long term solution needs to address M&A.

  8. D. Christopher Leonard

    A couple of brief observations: I remember a spate of articles from a decade or so ago that all asserted that the U.S. was ‘overbanked” (I think Economist participated and, if memory serves, New England Economic Review -amongst others). Concentration into universal banks along the European model (or Canada) would be more efficient and rational. Of course, no mention (that I can remember) of a more comprehensive regulatory regime to match.
    I find it peculiar that ‘culture’ only gets invoked in economic arguments (writ broadly)when things go awry. Otherwise, as one economist phrased it, ‘culture is null’ by which is meant epi-phenomenal.
    Yet, now there is a sustained interest in the specific form institutions take at historical moments that have (continuing) path-dependent consequences.
    The author of the commentary appears to have two conceptions of culture in play: 1. the capacity of superiors in a hierarchy to exact compliance in both orientation and action from subordinates (something like what Foucault meant by governmentaility), and 2. a nebulous set of beliefs, norms, dispositions that orient action (closer to the traditional anthropological concept).
    I think he’s quite right that there is at least ‘cognitive dissonance’ when large corporations are combined. but then the- or even Weber) assumption is that power (the capacity to elicit compliance) is all that matters in the name of efficiency and rationality.
    These issues may not be even scale-dependent.
    Perhaps Canadian banks (I don’t know) look different not be size and scale but by ‘culture’ and the regulatory environment?

  9. If mergers are bad for companies, the market should (eventually) correct it. But mergers may be good for companies and bad for everyone else. In finance, rents from size accrue due to TBTF, but elsewhere there are still rents (as opposed to economies of scale) to be had from size.

  10. I’ve hated banks for over 25 years and keep all my money in credit unions. My husband has, too. I watched the buyups and mergers of banks and just shook my head, figuring it would all end badly. After dealing with JPM for FOUR YEARS to close my mom’s very simple estate, I loathed them and the other big banks.

    Ignored them? Not me. I have a lot of schadenfreude watching them fail. I just wish my taxes weren’t bailing them out. Let them fail already.

    I wanted to start an educational software company after getting my MBA. Doing a business plan convinced me that Microsoft was destroying that market, and most of the educational software companies would soon be gone, so I never started a company. A few years showed I was right. Large companies destroy so many niche markets, so many companies, so many lives. It is hard to explain how much I resent them, really. They couldn’t care less about their customers, really, or their employees, which is why real wages have stagnated or declined since the 70s while CEOs reaped mega profits and salaries.

    Economies of scale are diseconomies for customers and consumers. Maybe most people are willing to put up with it, not me. I deal almost entirely with small companies and those that share my political goals as much as possible.

    The dinosaurs need to die, and deservedly so.

  11. Your software example also holds for the effect of Target/Walmart and Home Depot (etc.) on small town general stores and hardware stores.

  12. Insightful analysis based on practical experience and consistent with the findings of study after study which conclude that 60%+ of mergers fail to deliver the anticipated benefits. We also know that “large” does not necessarily lead to enhanced benefits for the marketplace or society (autos, telecom, banking, as examples).Additionally, a variety of studies conclude that small and medium-sized companies generated virtually all innovations and net new employment over the past decade or more.

    The evidence is pretty persuasive that size does not automatically, or even frequently lead to the presumed benefits, perhaps other then to the leaders of the companies, while a more productive, competitive and innovative environment results when there is compeititon between relatively smaller companies.

  13. If mergers are bad for companies, the market MAY OR MAY NOT eventually correct it. All people die of something, and all companies will someday die of something. People may die of some negative choice they made, they may die of something inherent genetically, they may do everything in their power to avoid a certain death and die of it anyway. They may die because they’re placed in a spot that makes it fairly easy to die. On the other hand people make many negative choices that never wind up killing them in the short or the long run.

    The same holds true for companies. The myth of the perfect competitor or the perfect consumer is responsible for an infinite amount of bad economic theory. The field of business is as chaotic as anything else in life.

  14. A very very insightful and detailed analysis about the American capitalism and its Achilles’ heel. The ever controversial topic of bigger is better has been very well researched and presented.

    If all sorts of mergers are indeed good,we probably wouldn’t have had so much blood on our hands today. The main problem according to my own view is that many banks did hastily execute deals without much insight into the ‘packages’ that might have crept in. Although I do concede that the recession is global and has its own effects on banks of all sizes, it is also a matter of common sense that even today much smaller banks HAVE indeed done better and remained healthier than their ‘Too big to fail’ counterparts that have done nothing more than further systemic risk of failure.

    And I’m also of the opinion that executive compensation caps should never be imposed!

    A wonderful post though!

  15. I started out as a lawyer in the ’80′s, when that field was burgeoning bigger too. As I set out into my small solo practice, my colleagues were muttering nostrums like: “If you aren’t expanding you are contracting.”

    Um, NO. The physics of that is wrong, which ought to suggest, to anyone that can think, that the whole fantasy of endless expansion is wrong.

    Like the time, in the ’60′s and ’70′s when people started insisting that it was wrong to repair small appliances because it was cheaper just to discard and buy new.

    When the physics — the environmental science — is wrong, you must consider that the social science maya be wrong too; but we engorged happily instead.

  16. bobgreenfest

    As far as banks go, the downfall was when banks were redefined with the repeal of Glass – Steagall. When banks took in deposits and loaned money to its depositors, the way Frank Capra had envisioned George Bailey doing it, the industry and requisite government regulation made sense. Once banking become investment banking and merchant banking and a series of acronyms which was nothing more than greedier and greedier ways to take money from others and circulate it among the in crowd, government regulation and financial backstopping made no sense.

    For additional insight into this and other financial matters please see http://www.bobgreenfest.wordpress.com.

  17. From my experience working on a couple of software projects for one of the banks being stresstested, your comments about the banks, IT, mergers and how disfunctional it all is are spot on.

  18. Interesting glimpse into a world where information technology gave us rope to hang ourselves. Good thing we have matured beyond that. Now that we are savvy, there is no need to worry about electronic health records, health insurance consolidation, NSA telcom spying, tiered internet pricing or other IT threats. Now we know better.

  19. Tom Shillock

    As for the internal coherence of large corporations, it is not just that employees in large divisions are strangers to one another that causes inefficiencies. That can be overcome. However, overcoming inconsistent business objectives between different divisions of a large corporation is not easy, formal controls mask political maneuvering. Ironically, one management technique intended to make large corporations more efficient, viz., internal competition between divisions in which each treats the other the way it would another company, reduces the efficiencies of cooperation from being in the same corporation and “culture”. Perhaps a further irony is that scaling up corporations leads at some point to organizational problems not unlike those faced by large public entities such as cities or states in which planning and bureaucracy supercedes anything that could be called entrepreneurial. How do policies reflect the fact that large corporations are different in kind not just degree, that ineluctably as things scale up new kinds of problem emerge?

  20. I’m pretty much the guy described in that first sentence. Having said that, my first reaction to this piece–as it has been to similar pieces tied to the theme of management-gone-superficial–is: Where were the internal wet blankets, and if they did speak up, why didn’t they speak louder? Granted, I realize that small profits can drown out even the most vehement dissent (and also, this is coming from a 25 year-old know-it-all in a small engineering firm, where I’m sure egghead objections are looked upon more kindly than a multinational finance giant), but I just don’t understand how highly educated people within the organization–no matter how lapdog-ish or indifferent–could watch these developments without making waves over the absurdity of the green bar on the PowerPoint or the three-decimal-place low-confidence metrics spit out of convoluted models. I think the narrative underreported in the whole banking meltdown is that of the outspoken skeptics, i.e. Did they exist? How many? Were they told to shut up and sit in the corner? Fired? I’m curious.

  21. edwinlee37

    On the too big to fail issue the following was posted today on my own blog at http://www.dismountingourtiger.com :

    May I suggest that large companies or banks with more than 10% market share are intrinsically anti-free market and anti-capitalistic. Two key benefits of free markets are that competitors succeed or fail based on competitive merits of their products, tactics and strategies and decision making and risk taking are sufficiently distributed to develop and identify an adequate supply of leaders from generation to generation to sustain a meritocracy. In order for the free-market to filter the weak and reward the strong with statistical confidence, there must be at least 12 relatively equal players in it.

    However, the economies of scale enable poorly run large companies to succeed at the expense of better run small ones; and large companies continue to scale up until their dominance is based on sheer size. They maintain dominance by buying the support of government… the only viable strategy for large companies, so it should be expected. In a nutshell, small players in a market survive by adapting, large players survive by controlling market expectations.

    Our social and legal institutions must make it difficult for large companies to grow ever larger… so that they may succeed or fail without requiring government intervention or destroying the free market in the process. What we are doing now is trying to close the barn door after the horses got out. Nature limits the advantages of size in the web of life by effectively imposing term limits on all individuals and upon all species. We have created “corporations” with unlimited lives (early corporate charters for banks and corporations were limited to 21 years, but successful lobbying by corporate boards in the Netherlands, England and the USA eventually made their charters eternal).

    We will not solve the problem of “too big to fail” until we impose term limits on large corporations (probably 60 years), and size restrictions (effectively imposed by multiple layers of soft regulations) that effectively require companies to sell off parts of themselves as they reach national market share limits. Anything short of these measures will simply fail with time as management of large companies will have the capacity to lobby public opinion and governments to give them a free hand; and survival instincts will compel them to do so. Enacting size and duration limits requires a deep understanding of what makes the free market so desirable.

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  23. Anthony Hogan

    I have actually had the fortunate opportunity to work for Lawrence in a previous role, always found him to have great insight and a willingness to embrace the larger picture…to include the human factor, which is rarely found in leaders today. I enjoyed the article. While not wanting to drag other sectors into the discussion, I would probably add that title “Too profitable to change” to the mix. Companies that continue to grow often lose sight of the longer term. They become apathetic to positive change and do what they can to ride existing rails. Example: Microsoft…contiues to launch basic products with problems, but is too profitable to really change their business model (we are still getting 20 versions of Windows). U.S. car manufacturers…made so much money we not only missed the four cylinder era, but quality and efficiency along the way. Oil companies are only now really looking for fuel alternatives they can charge people for instead of pushing to stop them. The companies made (and are making) too much money to stop their practices.

    Lawrence’s point about the culture is also true. Too many companies use the “tools” of quality and efficiency versus actually creating a culture that works towards it. Great example, Six Sigma. How many of the companies that have lost innovation, failed or are struggling in spite of hailing their dedication to six sigma as what will drive the right decisions? I have worked for a few of them and seen first hand the negative impact of clinging to tools versus understanding the value of improving the culture.

    Passing more laws is like having a bandage on a wound, there could still be trouble underneath that you won’t see until they bleed through. I agree we need laws, but what will truly change the way we do business is if boards hold companies truly accountable versus taking perks for sitting in a chair. Companies need to limit how many shares they sell to single entities…large investment firms can push a board and company to quarter-by-quarter goals versus longer term strategies. When it comes to size, I don’t think it really matters as much as if an entity is failing and needs help, all senior people and board members need to be handed their hats and escorted from their posts without any compensation at all, regardless of parachute contracts.

  24. Two comments/observations:

    First, it would seem that business schools have failed to evolve with the times. The executives orchestrating these mergers, which obviously make sense based on the numbers, essentially merged themselves into a corner. They didn’t have the skills necessary to establish a management culture/structure sufficient to direct these corporate behemoths. It would appear that the captains of these supertanker-like organizations have failed to comprehend the absolute magnitude and complexity of the ships they are steering. I’ve often heard that it takes a super-tanker something on the order of several miles to stop or simply change direction, and that is with a skilled captain at the helm. It would seem that we have had so many Joseph Hazelwoods (see Exxon Valdez) directing the course of these companies. Well-meaning individuals, probably. Competent, not. I guess that corporate executives believed that the legions of MBA’s in their employ would have been able to help them manage these unwieldy organizations, but the business schools failed to prepare any of them for management of organizations of this scale.

    Secondly, in many instances size is clearly a competitive advantage. Regardless of how well it is run, a country like Sweden, France or Switzerland will never command the absolute power of a US, Russia, China, India or Brazil. So, in the quest for achieving competitiveness, I would not necessarily call for legislation ham-stringing corporate merger activity. However, it would seem to me that perhaps a bastardized version of pay-to-play should be enacted. Allow banks to be as big as they want, so long as they are required to self-insure their existences. If all that the CEOs of these companies can understand is numbers, then make it that easy for them. If they want to leverage themselves 30 times, then place on them an obligation to insure some portion of that risk. Currently, the US taxpayer has unwittingly become the source of that insurance, which has led to a failure to fully appreciate the nature of the consequences of their actions.

  25. I’m a little late to the party but I’ve bee chewing on this for a couple of days.

    “ And the truth is that much of the modernization was needed. The rickety structure of bank regulation in America was not only odd by comparison to some foreign competitors, but the system of “non-bank” finance companies, securities and insurance companies purveying credit and other “bank-like” products had reached a scale that all but rendered the traditional framework of banking regulation a farce. It is hard to gainsay the wisdom of many actions taken by the deregulators, at least as far as well established and well understood financial products were concerned, and at least as far as deregulation sought to break down the very real barriers to competition that genuinely archaic restrictions provided”

    So, in short, what he’s saying is what we needed was a modernisation of the regulatory system and what we got in stead was deregulation. How is that not a failure on the part of regulators.

  26. Nassim Taleb has an interesting take on the topic of the big getting bigger. He says that it is an inevitable part of any human-constructed system. He calls it the “winner-take-all” syndrome, and he demonstrates it in celebrity, book publishing, the internet, and wealth. It explains why all these systems display a power law distribution.

    I’d love to hear his take on the effects of this syndrome in banking, but the question remains. If he is right, is there really anything that can can be done? Would any possible solution be counterproductive? Note that Taleb doesn’t give his opinion about the morality or utility of the phenomenon, just that it exists (and always has and always will).

  27. This is a bit rambling, but it sure rambles through some interesting and important terrain. Nice work.

    On the other hand, it doesn’t really address the crux of the super-size issue: It is unsustainable. Concentration of power leads to concentration of wealth, which ultimately results in a fragile economy in which too much of the resource base is tied up in huge vertical structures.

    Think of an old forest where no light or water gets down to the floor. Sooner or later a storm will blow down the old trees and the cycle begins anew.

    Or just look at the pattern of imperial overgrowth and collapse. We’re seeing it all over again, albiet in a more decentralized way. Rather than one emperor, there are herds of them competing for the diminishing business that remains in looted local economies.

  28. Professor Baxter’s post describes not just the growth of an industry but a change of its culture as well. While I agree that the arrogance of its leaders or even some plain misguided judgment of how gigantic banking corporations could avert risk needs to be addressed, I fear that too much attention is being paid to the “Too Big to Fail” topic and less to what actually brought global economies to their knees. Would hundreds of small banks rather than half a dozen large banks have made a whole lot of difference so long as CDSs were still unregulated? In 2006, the global economic output was $47 trillion while the amount of derivatives outstanding was $472 trillion. By 2007, the notional value of all OTC derivatives was just under $600 trillion. In essence, one hundred people taking out insurance on my mortgage (one asset) is unsustainable, regardless of how many banks are doing the trading. Wouldn’t the downturn of the housing market, causing mortgage defaults and the crash of CDSs have occurred no matter how many banks, big or small, were involved? Wouldn’t we still have had to prop up a banking industry in order to just have a banking industry while we figured out who to blame and what to change?

  29. Hoi Polloi

    Studies prove that more than 90% of corporate mergers and acquisitions are falling short of their objectives. Most mergers are initiated by megalomanic CEO’s who overlook the vital intangible assets such as business culture, company strategics, human capital, company structure and corporate governance.

    But what can you expect from people who only move in the highest management levels and are only use to look at computer models and balance sheets,,,

  30. First, the numbers and bankers’ opinions always show that every deal that’s done makes sense. Subsequent events and studies show that most mergers fail and destroy value. In truth, the shotgun wedding of BoA and Merrill is only marginally worse than many public company mergers. The problem isn’t one of learning in business school but after school in business. The problem with very large organizations isn’t size, but purpose, focus and “culture”. Simply stated, these deals are the sports equivalent of combining a pass oriented offense with a running one and thinking you’ll have a better team. It just doesn’t work that way.

    On the second point, if you allow them to get as large as they want, taxpayers have to pay the bill when they blow up. Not a good outcome. Banks at 30x leverage is asking for a disaster. The officers and directors should be required to put their personal assets and net worth on the line up front for these bets–bet they wouldn’t make them.

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