Are Big Banks Better?

Last week, Charles Calomiris wrote an op-ed in the Wall Street Journal arguing that big banks are better for various reasons. Simon wrote last week saying that Calomiris underestimated the political dimension, and that his proposed solution — a cross-border resolution mechanism for large institutions — is the policy equivalent of assuming a can opener.

I wanted to look at Calomiris’s specific claims. I think I’ve already dealt with the myth that banks “need to be large to operate on a global scale—and they need to do so because their clients are large and operate globally.” Calomiris also argues that there are economies of scope (it’s better to be big because you can play in multiple businesses). Here’s his evidence:

“True, some empirical studies in the field of finance have failed to find big gains from mergers. But those studies measured gains to banks only, and measured only the performance improvements of recently consolidated institutions against other institutions, many of which had improved their performance due to previous consolidation.

“Yet even unconsolidated banks have improved their performance under the pressure of increased competition following the removal of branching restrictions, which permitted the consolidation wave in banking. And when an entire industry is involved in a protracted consolidation wave, the best indicator of the gains from consolidation is the performance of the industry as a whole. One study of bank productivity growth during the heart of the merger wave (1991-1997), by Kevin Stiroh, an economist at the New York Federal Reserve, found that it rose more than 0.4% per year.”

Note that Calomiris concedes that you can’t find benefits from mergers by looking at merged banks directly; this is why he falls back on an industry average.

First of all, there must be a joke to be made here about correlation and causality. Wait, here it is.

Second, 1991-97 was only the beginning of the merger wave; The Riegle-Neal Interstate Banking Act wasn’t passed until 1994. Let’s assume that mergers after 1995 wouldn’t show up in the 1991-97 data. That includes Nations-Boatmen’s, Nations-Barnett, Nations-Bank  of America, B of A-FleetBoston, Chemical-Chase, Bank One-First Chicago, J.P. Morgan-Chase, Wells-First Interstate, Wells-Norwest, and Wachovia-First Union.

Third, I was interested by that statistic, because 0.4% annual productivity growth from 1991 to 1997 seems like nothing to write home about – labor productivity growth (the figure you usually read about) over that period was about 1.7% per year for the economy as a whole. So I tracked down the source: Kevin J. Stiroh, “How did bank holding companies prosper in the 1990s?,” Journal of Banking & Finance, Volume 24, Issue 11, November 2000, Pages 1703-1745. (I’m not sure if anyone can download the paper or I could only do it because I’m on the Yale VPN.)

I found out that Stiroh is measuring total factor productivity, not labor productivity, so 0.4% is better than average for the non-manufacturing sector. (The economy average was 0.3%, but the manufacturing sector was 1.9%, so by implication the non-manufacturing sector was less than 0.3%.) So far, so good.

But what does Stiroh say about this productivity growth? His main explanation for the productivity growth is not consolidation, but information technology: “The finding of steady productivity growth, in particular, is important since it is consistent with the idea that the massive investment in new technology is working to improve the performance of the banking industry.” This is not proven in this paper, but Stiroh went on to write a bunch of other papers on the link between information technology and productivity. For example, this paper (on the entire economy, not just banking) concludes:

“IT-producing and IT-using industries account for virtually all of the productivity revival that is attributable to the direct contributions from specific industries, while industries that are relatively isolated from the IT revolution essentially made no contribution to the U.S. productivity revival. Thus, the U.S. productivity revival seems to be fundamentally linked to IT.”

That second paper also finds (Table 2) that productivity acceleration — the difference between productivity growth in the 1995-99 period relative to the 1987-95 period — was lower in finance, insurance, and real estate than in the economy as a whole, including the services sector. I don’t know exactly what this means, but at first glance it doesn’t look good for banking consolidation.

Going back to the first paper (the one Calomiris cites), what does Stiroh say about bank size? “Despite the strong overall performance, roughly 10% of costs were due to inefficiency and 30-40% of potential profits were missed. Moreover, efficiency does not significantly increase with bank size as one might expect if economies of scale are an important determinant of success. Rather, there are efficient and profitable BHCs in every size class and increased size does not guarantee success.” Figures 6 and 7 show that there is no difference in cost efficiency across size classes and that the largest banks actually seem to have lower profit efficiency.

However, Stiroh also says that continuing consolidation seems to offer the possibility of reducing these inefficiencies, so on balance I would say he is slightly positive about size. Stiroh also has a paper on banks in Switzerland which I didn’t read, but whose abstract says:

“We find evidence of economies of scale for small and mid-size banks, but little evidence that significant scale economies remain for the very largest banks. Finally, evidence on scope economies is weak for the largest banks that are involved in a wide variety of activities. These results suggest few obvious benefits from the trend toward larger universal banks.”

I wish I had more time to read more of these papers. It seems to me that Stiroh has done a lot of serious empirical research on banking productivity and finds the evidence mixed — consolidation should be good, but it doesn’t really show up in the data. I haven’t read much of his work (or talked to him) and I certainly don’t want to imply that he is against big banks. I just think that citing a study he did of the 1991-97 period to back up a claim that banking mergers are good is a bit of a stretch.

By James Kwak

38 thoughts on “Are Big Banks Better?

  1. In Europe ING is breaking up and it could be a first step in the right direction with the end of the banassurance model and back to some narrow banking. Was it just moral suasion of regulators or pragmatic dutch approach to business?

  2. Bank productivity growth? What exactly do banks produce besides financial instability? Does the writer mean that it takes increasingly fewer bankers to bring down the financial system? I suppose that is true.

    James- You wish you had more time to read these papers? Can’t you get to sleep any more just reading The Common Law? That worked for me in the old days at Harvard.

  3. “Couldn’t the time have come to put PEOPLE ahead of profit?”

    Would re-framing the debate that way get the message across quickly to more people?

  4. I just think that citing a study he did of the 1991-97 period to back up a claim that banking mergers are good is a bit of a stretch.

    Indeed. It’s even more of a stretch to cite a study of 1980-1993 mergers to disprove the claim that “the latest banking mergers created great value.”

    That’s what Simon Johnson did, just last week (, citing this study:

    Double-standard, thy name is Baseline Scenario.

  5. Is Charles Calomiris cherry-picking data??? Interesting to note Calomiris also co-directs the Project on Financial Deregulation at the American Enterprise Institute. I would assume that’s a paid position. I got that info from this link.

    According to Wikipedia Dick Cheney and Dick Cheney’s wife are senior fellows at the American Enterprise Institute (Dick Cheney is also a trustee). Newt Gingrich is also a senior fellow at the American Enterprise Institute. American Enterprise Institute also hired Paul Wolfowitz to work as visiting scholar after he worked as U.S. Deputy Secretary of Defense under Don Rumsfeld and after he was forced to give up Presidency of the World Bank because of allegations he improperly acted to benefit his girlfriend.

  6. Consolidation should be good, but it doesn’t really show up in the data.

    Gosh darn it when that pesky reality refuses to cooperate with pretty ideology.

    So Calomiris’ alleged causality looks bogus, and is better explained by the IT surge. That seems to be the case for a lot of bogus credit-taking for whatever actual growth there may have been in the 90s.

    IOW, as always, it was actual workers who created whatever was created, while the masters of the universe were really only masters of parasitism.

    And of course, all of this elides the real question and the real truth.

    Where’s the omelette? Financialization promised prosperity for all. It’s had forty years. What’s the record?

    Scorched earth across the board: jobs, wages, working conditions, the safety net, wealth distribution, all public amenities, social and economic stability, democracy itself.

    The finance sector promised, in return for being allowed to exist, that all of these would be enhanced and universalized in America. Now we know that promise was a complete lie.

    So it’s really cute to see a mercenary like this digging through reams of data to find one stale number (and such a picayune one at that) he can distort so that if you squint really really hard, it sort of looks like big banks “did a little better” than smaller ones.

    And who is he implicitly saying did better? Just a handful of bankers!

    And for the sake of just them we’re supposed to submit to eternal slavery in the cold and dark.

    These guys really have some nerve, and we’ll just see where we’re all headed with this.

  7. Better for whom?

    Let’s just admit that we aren’t all in this together, and that the financial services sector has defined itself in an adversial posture vis-a-vis the needs the rest of the economy (and the community at large). As predators, the banks and other financial firms require regulation and discipline, perhaps decapitation. As parasites on more productive elements of society, their apologists should not be permitted to highjack concepts such as ‘innovation’ or ‘productivity’.

    The financial services sector requires pruning, reshaping, perhaps uprooting and replanting. Sucking the air out of the room with compensation reform is a first stop towards stopping the breathing of the people in charge. But a stake through the heart still awaits . . .

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    I’m contacting you because I found your site in a health reform blog search and want to tell you about my newest blogging platform —the public concern of health care and its reform. Our shared concerns include health reform, tort reform, public health, safe workplaces, and asbestos contamination. I apologize for leaving this message as a comment but I could not find an email address to reach you.

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  9. You’d think that these are the very “free-market” kind of folk that would understand that monopolies are detrimental to a free market.

    But neocon *fascists* point to monopolies, wave the flag, and claim that it is best for the strength of the nation, etc. The Obama administration hasn’t done much to change this…

    This whole economic/financial crisis is a political crisis with financial/economic consequences. Pretending that the economic disaster can be resolved to the benefit of “We the People” without addressing
    the political problem (as pointed out by Johnson and Kwak again and again) is the consequence of smoking “green shoots”. I think that the current situation has clearly shown that both R’s and D’s are bought and paid for by corporate interests- and partisan bickering about anything is nothing more than re-arranging deck chairs on Shakleton’s “Endurance” (because it took almost a year to sink).

  10. While there is much that most followers of this blog agree on, I have seen diverse views posted regarding whether big financial companies should be broken up, or whether they can be tamed through regulation. This is a multifaceted question, but it obviously raises the question posed today: is there any benefit to be derived from the existence of huge financial institutions. If not, then break-up has no down-side and is the way to go. If so, then we have to ponder the trade-offs entailed by break-up and weigh that against what might be achieved through regulation.

    Having just said the obvious, I’ll get to my point. The question of whether large financial institutions confer benefit on society is a crucial one, and it is in large part an empirical question. Since you don’t have the time to go into this in further depth, why not invite Stiroh to do a guest-post on the topic?

  11. Not only can’t you make an omelette without breaking eggs, you can’t seem to make one without letting seven guys own all the chickens. George Soros (of all people) has an interesting recent interview in the Financial Times. He claims the answer is replacing the dollar with international funny money. I think he puts the US essentially in the category of 1946 Britain or France (dead in the water).

    I think it was Emma Goldman who said if elections changed anything they would stop holding them.

  12. After the 1719 South Sea Bubble in England, a popular Parlementary remedy was execution and property escheat for those in government deemed responsible.

    Perhaps an example or two would certainly get the attention of those now in charge?

  13. Haven’t you had enough benefits during the past year or two? I’m not certain we can afford very many more similar benefits. On the other hand, for those who like asset bubbles and throwing darts at the stock listings and gambling with other peoples’ money the benefits can be outstanding if you are still young enough to get a job on Wall Street.

    Is this really too high a price to pay for a cheap mortgage loan on a house that costs twice what it should cost? What does Colamari think?

  14. In Simon’s defense, at least the study he cited did back up his point. The study Calomiris cited doesn’t even back up his.

    Also, though this may sound like hair-splitting, I was contesting Calomiris’s statement that 1991-97 was “the heart of the merger wave,” which it clearly wasn’t. Simon cited that other study as support for the general point that mergers don’t yield benefits.

  15. I am at a loss as to why there is any discussion at all on the benefits of concentration in a corner of the economy. The US passed anti-trust laws over a century ago – it was decided then that monopolies were detrimental to the US. Has something fundamental changed in the nature of humanity since then that we should expect any different result should anti-trust laws be repealed? This falls into the “repeating an action and expecting a different result” category. Break up mega-corporations already, and if they want to flee the US to a place where they can legally exist – let them, but make sure they can’t operate here ever again.

  16. Simon cited that other study as support for the general point that mergers don’t yield benefits.

    No, Simon cited the 1980-1993 study as evidence against the claim that “the latest banking mergers created great value.”

    Banking mergers that occurred in 1980-1993 are indisputably NOT “the latest banking mergers.” That makes Simon’s use of that study fundamentally inappropriate. Full stop.

    If you’re going to split hairs, at least make sure your argument is accurate. What are they teaching you kids in law school nowadays?

  17. If we’re strictly arguing timeframes and only timeframes, both studies are valid. People still study The Great Depression for answers (and for good reason) and even go back to the 1800’s to study the Federal Reserve/monetary policy et cetera. Roughly from 1933 until 1999 investment banks and commercial (retail) banks weren’t allowed to merge anyway. So the data would presumably be thinner then. Other than the S&L crisis (caused by DEregulation) there were ZERO bank crises during that time ( ’33 to ’99) to research.

    One thing I will say in defense of James Kwak and Simon Johnson is MANY sites/blogs would have pulled that criticism off the site. Or do what some Editorial pages/blogs do, choose to air the most bogus or badly worded criticisms to air. James Kwak deserves kudos for letting the criticism remain in view. It shows some integrity.

  18. Agree.

    Again, the problem is that the current framing is about “better” for those at the center of the businesses that are getting bigger.

    I dare say, Capitalism isn’t about what is best for business, but is suppose to be what is best for society.

    Capitalism cannot – and does not – work (i.e. create value for the consumer – whether of goods, services, or labor) when competition is driven from the marketplace.

    The profit-motive, which drives some businesses towards monopoly, MUST be countered by regulation to keep competition in the marketplace. This requires not only strong and enforced anti-trust laws, progressive taxation, an educated populace, & money for R&D, but it means corporate and monied interests need to be parted from politics.

  19. What has changed is that political economy was eclipsed by economics. In economics one starts with bogus assumptions and then proves we live in the best of all possible worlds except when government attempts to interfere with monopoly. A person can peddle this notion all the way to the US Supreme Court unless he is simply unlucky and must settle for a seat on the Court of Appeals and a sinecure at the University of Chicago.

    Another popular branch of economic wisdom holds that markets are always rational; therefore, interference with markets is always wrong. Proving this with advanced mathematics will get you a Nobel Prize which you can still keep after you blow up a billion dollar hedge fund operated on the premise you have proved.

    Now if YOU can only prove by advanced mathematics that interfering with offshore capital accumulation and tax evasion and banker profits improves the welfare of those now satisfied with electing an Obama, perhaps we can return to 1890 or at least 1914. Otherwise we must settle for government by GoldmenSack and lectures from squid.

  20. Seems to me good management will trump bad management on the productivity stats no matter what the size (assuming the stas are derived from honest numbers). I also have a theory that bad management is not obvious when economic times are good, only when they start going bad. We either need early warning signals that bad management is happening and a way to replace it, or we need to limit the impact bad management can have on the overall economy. Limitations on the size of banks and/or the types of business they are allowed to conduct would be one way of doing this.

  21. Yes. The age old debate of quantitative model vs. empirical evidence. Silly folks with their models forget that reality trumps the model every time.

  22. I would note that you are talking really about whether merged banks are better for themselves, as opposed better for the generalized economy. I really don’t think that there is much question that they are better for themselves, although really this may not be true in a normal regulatory environment (we haven’t had super banks back in the days of real banking restriction (pre Glass-Steagall) so we really may not be able to be sure. The main problem as it see it is that they tend to tie up large amounts of capital that only gets exposed to their profit churning, and which misses being distributed into the rest of the ecomony. That is that they probably now are using up about half of all available capital in economic churning for easy profits, ala Las Vegas, and not assisting in the real economy because their “ordinary banking business” is much less profitable that their role in investment banking.

    After all, if we look at the bigs, they are really nearly out of the local lending business, and marginal on the bigger deals. So big is strangling the economy. I don’t have access to the kind of statistical support, but this is how ita appears. It would be nice to know if I am right in my perception. Maybe you or Simon can shed some light on this. It is very topical, since we are trying to regulate AND INCENTIVIZE BETTER BANKING PRACTICES IN THE TBTF REALM.

  23. What is the expected effect of FASB 166 and 167 on TBTF banks?
    Will they be given waivers (again)?

  24. sounds nice but will it be effective?
    they change names re-configurate merge and acquire as long as it takes them to become unrecognisable and swish they’ll be back

    – so maybe a regulation that defines what of this stuff is obfuscating and what is sound business should be invented????
    Would probably take Douglas Adams’ supercomputer to come up with a definition which would then be an equivalent of 42

  25. James Kwak:

    Your arguments seem awfully compelling regarding the problems created by big banks, but the one question I have is how to make sense of the Canadian banking system. They have a banking system dominated by a few large banks that appear to have weathered this crisis well. As I recall, the Canadian banking system also happened to have done much better than the U.S. during the Great Depression as well.

    One story I have heard is that the reason they have done so much better is because they have had interprovince branch banking through much of their history. This U.S. banking system, on the other hand, has been plagued by unit banking laws until a few decades ago. As a result, Canadian banks had more diversified portfolios of assets than U.S. banks and thus were less succeptible to economic shocks. If true, this implies banks should be big enough at least to have branch banking. So how does all of this fit in with what you and Simon have been saying?

  26. The differences between US and Canadian banks are that the Canadian banks are less than 10% the size of the US behemoths. The Canadian Government is seen as part of the solution by the electorate and have tightly regulated and inspected the Canadian banks. For example how did Harris Bank of Chicago a subsidiary of Bank Of Montreal fare compared to its virgin pure domestic competition. We should also look at the source of senior management the business schools and their product the MBA/Lawyer/Economist fraternity. I use the word fraternity because I see many honest forthright women trying to put things right. I see many over educated,overpaid men worshiping at the altar of false gods and benefiting from it. I might add that I also see a very docile easily gulled population. In time I have no doubt that the US will survive what Regan started and will rechart the course to prosperity.

  27. Actually, it doesn’t seem to me that Canada’s regulatory system is all that dramatically different from the American one. Canada did however experience a collapse in their derivative market or asset backed commercial paper (ABCP) as it is known there in August of 2007 and investors fled the market a full year before the crisis hit in the U.S. (The crisis there being blamed, not surprisingly, on lax regulation.)

    See this article from September 2007

  28. Big banks offer some advantages smaller, or local banks do not, – but this reality does not in anyway support the need for criminal oligarchs, who injure the American public and rob us of our taxdollars.

    No one, and NO THING is to big to fail.

  29. The title made me laugh…
    Good rebuttal.
    Having been through a number of mergers and reorganizations, I find it really hard to believe there is any economy of scale to be had since (IMO) the best talent usually leaves, and the dead wood stays (Disclosure -I’ve been both). I know there are exceptions, but in the short run the odds are against quality improving. Over time it gets better but in the first year or 3 after, *Phew*!

  30. There’s another advantage that big banks have that you don’t seem to have mentioned. Bigger banks are able to shield themselves better from shocks. When there is a shock affecting one of the sources of funding for a bank then bigger banks can insulate themselves from this shock by obtaining other sources of funding. Small banks may not have access to these other sources, or may have to pay a bigger premium for external financing. There is decent evidence for this being the case. Some of the evidence comes from the bank lending channel/credit channel literature eg Kashyap and Stein (2000). The bottom line is that bigger banks experience less in the way of financial frictions.

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