The Department of Justice seems to thinking, at least in principle, about potential antitrust action in and around banking.  Assistant Attorney General Christine Varney spoke about this yesterday, but her exact wording is open to interpretation, “”I have to ask if too big to fail is a failure of antitrust enforcement.”  (The press release was uninformative on this point)

More encouraging was the background briefing given to the New York Times, as seen in this paragraph,

“Ms. Varney is expected to say that the Obama administration will be guided by the view that it was a major mistake during the outset of the Great Depression to relax antitrust enforcement, only to try to catch up and become more vigorous later. She will say the mistake enabled many large companies to engage in pricing, wage and collusive practices that harmed consumers and took years to reverse.”

The thinking among antitrust experts has been that there is not much market power, conventionally defined, in financial services.  But this thinking may change, for at least three reasons.

1. There is definitely less competition now in investment banking (no more Lehman or Bear Stearns).  Banks are bragging that their fees and trading profits will consequently be higher.
2. Reportedly aggressive action by investment banks, vis-a-vis particular countries/securities, grab headlines.  One way to think about these alleged actions is an exercise of (socially destructive) market power.  Predatory practices are surely easier to get away with in a period of global confusion.
3. Changes in fees for overdrafts are beginning to attract attention.  This may be a matter for bank regulators rather than antitrust, or even for a financial products consumer protection agency to be named later (remember Joe Stiglitz’s recent testimony), but it does make you ask: what is the market structure that allows banks to do this?

There is an awkwardness to these concerns, of course, because Phase II of Larry Summers’ Recovery Model calls for banks to earn their way back to reasonable capital levels.  Banks know they now have a high level of political cover and are likely to act accordingly.  If the Department of Justice moves towards banks, it will presumably be stalled by Treasury and others.

Still, the legal system has a dynamic of its own.  And Carl Shapiro, Deputy Assistant Attorney General for Economic Analysis, is completely capable of thinking clearly about our new (?) Too Big To Fail economy – e.g., start on p.108 of his book for ideas that begin to be more broadly relevant to the debate on finance today.  With some help, he and his DoJ colleagues can figure out how best to bring public policy to bear.

Post your suggestions for them here.

By Simon Johnson

The Obama administration is strengthening its antitrust enforcement policy.

That said, this in itself probably wouldn’t have done anything about the “too big to fail” problem. It might have increased scrutiny over large bank mergers – like Nations-Bank of America, Bank of America-Fleet, or JPMorgan Chase-Bank One, but frankly those probably would have gone through anyway; the banking industry is just not that concentrated compared to some others. Too big to fail is a combination of size, interconnectedness, and the critical role of finance for the economy. But the signal that the administration will actually enforce antitrust law is a step in the right direction.

By James Kwak

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.

The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is duty bound to control them wherever the need of such control is shown.

Theodore Roosevelt, “Address at Providence,” 1902 (emphasis added)

By “creatures of the State,” Roosevelt meant not that corporations were created by the state, but that their existence and power existed because of and in concert with the state. A few years ago, someone reading this quotation would have probably thought first of Halliburton; today, it evokes the large banks that are too big to fail.

That quotation was pointed out to us by Zephyr Teachout, a law professor at Duke, who has been proposing new antitrust laws aimed at reducing the political power of large firms.

U.S. antitrust law was rooted in late-nineteenth-century hostility toward large corporations, but in practice became focused less on size than on specific anti-competitive practices. The Sherman Act of 1890 was aimed at collusion among companies to constrain freedom of trade, while the Clayton Act of 1914 went further in specifying anti-competitive practices, such as bundling or mergers that create excessive concentration in an industry. Over the past few decades, in part under the increasing influence of free-market economic theory, antitrust enforcement by the Department of Justice has become more tolerant of size and concentration in themselves, and has focused instead on whether mergers will benefit or harm consumers. On the one hand, increased concentration increases the ability of large firms to raise prices, hurting consumers; on the other hand, or so the argument goes, larger firms gain economies of scale that enable them to reduce costs and therefore reduce prices to consumers. (If you believe that, take a look at the price of text messaging on your mobile phone bill.)

So it seems likely that existing antitrust laws, as currently enforced, would be unlikely to do the trick of breaking up large banks. Even though the four largest banks hold about 60% of assets in the U.S. banking system, that’s not nearly concentrated enough to attract the attention of the DOJ. And while there may very well be illegal collusion among large banks, there is no smoking gun that I’m aware of, and you certainly wouldn’t need collusion to explain the events of the last decade, or the uniformly high prices charged for services such as equity underwriting. (One of the major implications of game theory, which was standard fare in first-year graduate micro by the 1990s, if not earlier, is that what looks like collusive behavior could also result from individual rational action.)

Teachout’s response is clear: write new laws. In particular, she argues, existing antitrust law does not address the problem of political influence.

There are many reasons a “too big to exist” conception of antitrust law makes good sense for a democracy. Perhaps most importantly, large companies have proven to have disproportionate power over the political process. Concentrated financial power often leads to concentrated political power; if you have a lot of cash, one of the most efficient uses of it to maximize profits is to petition the government to change the rules in your favor. Economies of scale might work all too well when it comes to influencing government.

This argument would barely have gotten a hearing in the 1990s and earlier this decade, when companies were scrambling over each other trying to merge, and the business media were constantly congratulating the “winners” in the battle to become big (even though, in most mergers, any actual gains go to the shareholders of the acquired company, since the acquirer invariably overpays). Now that we have official endorsement from a Republican administration that even the third-largest investment bank (Merrill) was too big to fail (and widespread regrets over letting the fourth-largest investment bank fail), and we have increasing recognition of the linkages between Wall Street and the federal government, the need for new laws may receive serious consideration. In addition, there is evidence (I’ll try to post on this another time) that, at least when it comes to banks, there is a size beyond which any economies of scale are outweighed by coordination problems, most tellingly in risk management. (And, there is the simple fact that large banks tend to charge higher fees, charge higher interest rates on loans, and pay lower interest rates on deposits than small banks.)

There is another, minority view, which is that a new approach to enforcing existing laws could be used against large banks. The general principle is that laws are defined by their interpretation. For an example, look no further than TARP, which gave Treasury the power to purchase “assets” of troubled banks, meaning things on the asset side of their balance sheet – and was prompty interpreted to mean that Treasury could buy preferred stock in those banks, which is only an “asset” from the perspective of the buyer, not the seller. Of course, to get your interpretation to stick, you may have to convince a court, in the antitrust case probably the Supreme Court. But it would not be the first time the Court has changed an interpretation that was once considered settled. For example, when the Court found an individual right to bear arms in the Second Amendment in District of Columbia v. Heller, 128 S.Ct. 2783 (2008), it was reversing a precedent that had not even bothered revisiting since 1939.

What would the argument be? Well, for one thing, having banks that are too big to fail, and then having to bail them out to the tune of hundreds of billions of taxpayer dollars, is clearly bad for “consumer welfare” in general. However, consumers under this argument are only being affected indirectly, so that argument may not stick. But perhaps someone can come up with a better legal theory here.

By James Kwak

In early February I suggested there was a showdown underway between the US Treasury and the country’s largest banks.  Treasury (with the Fed and other regulators) is responsible for the safety and soundness of the financial system, the banks are mostly looking out for their own executives, and the tension between these goals is – by now – quite evident.

As we’ve been arguing since the beginning of the year, saving the banking system – at reasonable cost to the taxpayer – implies standing up to the bankers.  You can do this in various ways, through recapitalization if you are willing to commit more taxpayer money or pre-packaged bankruptcy if you want to try it with less, but any sensible way forward involves Treasury being tough on the biggest banks.

The Administration seems to prefer ”forbearance”, meaning you just ignore the problem, hope the economy recovers anyway, and wait for time or global economic events to wash away banking insolvency concerns.  But this strategy is increasingly being undermined by the banks themselves – their actions threaten financial system stability, will likely force even greater costs on the taxpayer, and demonstrate fundamentally anticompetitive practices that inflict massive financial damage on ordinary citizens.

As the NYT reported yesterday, the Federal Reserve – on behalf of all bank supervisers – recently requested banks in no uncertain terms (1) not to reveal stress test results, (2) not to give other indications of their financial health, and (3) most of all, not to announce capital raising plans immediately.  The point, of course, is to manage the flow of information so that plans can be made to help the weaker banks at the same time that the market realizes exactly who needs what kind of help.

Amazingly, the biggest banks are defying the federal authorities on this point, insisting on signalling their soundness and – in the case of Goldman Sachs – rushing to raise capital.  In the case of Goldman, the explicit intention is to pay back TARP funds and to escape all government-imposed limitations on compensation.  This would obviously be good for Goldman and the people who run it.  Anything that strengthens their advantage over competitors and increases market share will presumably raise their profits and compensation, making it easier to attract even more good people.  (See my discussion with Terry Gross yesterday for more on these dynamics.)

Such developments would worsen the business prospects of other large banks and potentially threaten their financial situation.  The government’s forbearance strategy is fragile unless big banks do as the supervisers tell them.  But Goldman and other major players apparently think they have so much political power – and this may be more about connections on Capitol Hill than links with the Administration – that they can ignore the supervisers.

Treasury can try to refuse repayment of TARP funds, but Goldman would hardly have made its move unless repayment (particularly after announcing the intention) is essentially a done deal.  Supervisers can send more assertive emails, but these are hardly likely to have any effect.  The President himself can call on leading bankers to behave better, but didn’t he just do that (and isn’t that what Valerie Jarrett is working hard on)?

My practical friends in the Administration like to emphasize that “we are where we are” and that we need to understand the limitations of the policy tools in hand and the realities of our political constraints.  I completely agree.

The Department of Justice’s Antitrust Division should be called in to investigate the increasing market share of major banks (remember that Bear Stearns and Lehman are gone), the anti-competitive practices of some market leaders (there’s more than one predatory way to force your rivals into bankruptcy and to move closer to monopoly power), and the broader increase in economic and political power of the biggest financial services players over the past 20 years and the last 6 months – this is potentially damaging to all consumers and, obviously, to all taxpayers.

Think of the costs arising from the market power of major banks – and it is financial market power that makes them “too big to fail”; the FDIC has no trouble handling the failure and liquidation of small banks.  We started this crisis with privately held government debt at around 40% of GDP.  My baseline view is that we will end up closer to 80% of GDP.  This means higher taxes for all of us, and this is absolutely not a “left vs. center” or “left vs. right” issue.  This is left, right, and center against those parts of the center who insist that we should go back to having the same organizations, essentially unchanged compensation schemes (and all they imply about “Wall Street owns the upside and taxpayers own the downside”), and even more concentrated market power in our financial system.

Probably we need to modernize our thinking about the exact nature of threats arising from financial trusts.  Perhaps we need, at some point, new legislation that reflects this thinking.  But we can make a great deal of progress, here and right now, with appropriate enforcement of our existing antitrust laws.

The pushback, of course, will be: you can’t do this in the middle of a recession – it will slow the recovery.  Honestly, as my colleague Mike Mussa emphasized last week, banking is more likely to follow than lead the recovery; in fact, this is the exact logic that underpins the Administration’s forbearance strategy.

The goal of this antitrust action is to prevent some big banks from further destabilizing the system, hence reducing a serious downside risk.  It’s also to limit the taxpayer costs arising from this crisis; for all major bank rescues, the cost is not just the bailout, it’s also the higher fiscal deficit, increased debt, taxes down the road and – given today’s predicament – the very real inflation risks arising from even more monetary expansion.  The overarching goal, of course, is to (re)build a more sustainable, sound, and – in all senses – competitive financial system.

By Simon Johnson

We now interrupt our global crisis programming to bring you news from the rest of the economy . . .

Earlier today, the Department of Justice approved the merger of Delta and Northwest, which I believe closed later this evening. In its statement, the Antitrust Division blessed the merger, saying:

the proposed merger between Delta and Northwest is likely to produce substantial and credible efficiencies that will benefit U.S. consumers and is not likely to substantially lessen competition. . . .

Consumers are also likely to benefit from improved service made possible by combining under single ownership the complementary aspects of the airlines’ networks.

Now, for literally years, every expert on the airline industry has been saying that the industry needs less competition, less capacity, and higher prices (bad for consumers), and consolidation is the way to achieve that end. Put another way, if Delta and Northwest actually believed the DOJ’s statement, they wouldn’t have bothered merging in the first place.

I’m not saying that the DOJ should have blocked the merger – not being an expert on the airline industry (although I am an expert on flying on airlines), I defer to those who say mergers are necessary for the health of the industry. But since when did the DOJ become their PR firm?