Does Ben Bernanke Have The Facts Right On Banking?

Ben Bernanke, chairman of the Federal Reserve, has stayed carefully on the sidelines while a major argument has broken out among and around senior policymaking circles: Should our biggest banks be broken up, or can they be safely re-regulated into permanently good behavior? (See the recent competing answers from WSJ, FT, and the New Republic).

But the issues are too pressing and the stakes are too high for key economic policymakers to remain silent or not have an opinion.  On Cape Cod last Friday, Mr. Bernanke appeared to lean towards the banking industry status quo, arguing that regulation would allow us to keep the benefits of large complex financial institutions.

Note, however, that Bernanke’s quote making this point in the NPR story (at the 45 second mark) is from his spoken remarks; the prepared speech does not contain any such language.  And Mr. Bernanke is wise to be wary of endorsing the benefits of size in the banking sector – the evidence in this regard is shaky at best.

There are three main types of evidence: findings from academic research on the returns to size in banking; current and likely future policy in other countries; and actual practices in the banking industry.

First, while academic research is not always the primary driver of policy choices, it is relevant when we can readily see the costs of big banks (in the crisis around us) but the supporters of those banks claim they bring important benefits.  In fact, the available research indicates that in the banking sector, economies of scale exist only up to a (relatively low) level of total assets, while economies of scope are elusive. The benefits from diversification across countries or lines of business are also small; moreover over the last few months we learned that correlations among different markets and asset classes increase rapidly during a crisis – thus reducing even more the benefits of diversification.  [See “Consolidation and efficiency in the financial sector: A review of the international evidence,” by Dean Amel, Colleen Barnes, Fabio Panetta, Carmelo Salleo; Journal of Banking & Finance 28 (2004) 2493–2519.  Note that one of the authors works at the Federal Reserve Board, and all four work in a central bank or ministry of finance.]

Second, policy in other countries matters because some fear that breaking up big US banks would somehow put us at a competitive disadvantage vis-à-vis big European or other banks.  But on this issue the European Commission spoke loudly this week – ordering the break-up of ING, and the presumption is that they will also soon put similar pressure on big UK banks.

Interpretations of this action vary – some see it as an implementation of competition policy, while others feel the Commission is (rightly) concerned about the unfair subsidies implicit in government ownership and support for large banks.  The Commission itself is being somewhat enigmatic, but the exact official motivation doesn’t matter – the important point is that the leading pan-European policy setting organization, which does not rush into decisions, has determined that whatever the benefits of size in banking, the public interest requires smaller banks.

Third, in terms of actual business practice, any big investment banking transaction is done with a syndicate or group of banks – there is sometimes a lead bank with a favored relationship, but that role is definitely shopped around. 

Take, for example, General Electric’s October 2008 share offering, in which there were seven lead managers.  Or look at the prominent Microsoft bond offering, which had Bank of America, Citi, JPM, Morgan Stanley as lead managers and Credit Suisse, UBS, and Wachovia as “joint lead” (in this context, “joint lead” is the junior partner).  If a nonfinancial corporate entity takes out a large bank loan, this is also shopped around and syndicated – even for medium sized companies – so as to divide up the risk. 

Similarly, if a company wants to do a foreign exchange transaction, it searches for offers and take the best deal.  It would be unwise to rely exclusively on one bank – they will naturally hit hard you in terms of higher fees. 

One area where banks benefit from size is in terms of being able to put their balance sheet behind a transaction – e.g., to get a merger done they may offer a bridge loan, with the real goal being to get merger fees.  Bigger banks with a large balance sheet have an advantage in this regard. However, this kind of risk taking is also what gets banks in trouble (e.g., in the 1997-98 Asian Financial Crisis).  In the past, both Morgan Stanley and Goldman Sachs did not have large balance sheets but still did well in mergers and acquisition. 

Goldman is an interesting case because it had $217 billion in assets in 1998 (that’s $270 billion in today’s dollars); it now has around $1 trillion.  Goldman was considered a strong global bank in the late 1990s.  Can it really be the case that the idea size for banks has risen so dramatically over the past decade?  (Lehman had $154 billion assets in 1998 and above $600bn when it failed). 

For derivatives (and other instruments) it’s important to have deep markets, but not necessarily big banks.  If you want to buy and sell stock you want a liquid market, and the same is true for derivatives. 

If you are a large oil company, and you want to hedge future risk, your choices are:

1.  Hedge with a “too big to fail” bank, because you know taxpayers will bail you out and these banks are subsidized by their government support, so they can give you a better price. 

2.  Or you can hedge with several banks to minimize counter party risk.  They then sell of some of the risk – taking take less risk themselves as they are small enough to fail.

If you were hedging you’d prefer the “too big to fail” system because it comes with a nifty subsidy.  But this is not what the Federal Reserve should be supporting – Mr. Bernanke may still come out in favor of markets-without-subsidies.

By Peter Boone and Simon Johnson

An edited version of this post appeared previously on the’s Economix; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

35 thoughts on “Does Ben Bernanke Have The Facts Right On Banking?

  1. First, while academic research is not always the primary driver of policy choices, it is relevant when we can readily see the costs of big banks (in the crisis around us) but the supporters of those banks claim they bring important benefits.

    Um, haven’t we learned that academic research, for our purposes, is merely the rubberstamping of policy with charts and graphs? British understatement at work?

  2. Measured in ounces, Goldman’s balance sheet is almost exactly the same size as it was in 1998.

    If our government breaks up any of these banks, ever, I will eat my hat. I am pretty sure our government will have to be broken up first.

  3. The Geithner/Turner Plans are OK. There are some decent criticisms of Narrow/Limited/Utility Banking. However, the arguments against the current arrangement are self-evident, at least to some of us. The Geithner/Turner Plans simply leave too many switches for bankers and their enablers to play with. They might work, but, if they don’t, what will we do next time?

    Bernanke might be on the fence about this, because I am as well. It’s only because of the Moral Hazard Bonanza that has occurred that I’ve moved from favoring a strict application of Bagehot to Narrow/Limited/Utility Banking. As near as I can tell, that’s the reason that Simons, Fisher, Viner, and Knight, proposed the idea in 1933.

  4. For derivatives (and other instruments) it’s important to have deep markets, but not necessarily big banks. If you want to buy and sell stock you want a liquid market, and the same is true for derivatives.

    Deep and liquid markets require market-makers, and market-making in derivatives and other capital markets instruments requires — you guessed it! — A BIG BALANCE SHEET.

    Seriously, this is finance 101 stuff. Aren’t you supposed to be sophisticated or something?

    Note to self: Don’t hire anyone from MIT Sloan School this year.

  5. “Mr. Bernanke may still come out in favor of markets-without-subsidies.”

    Um, no he won’t. I’m 100% with Nemo on this one.

    “Deep and liquid markets require market-makers, and market-making in derivatives and other capital markets instruments requires — you guessed it! — A BIG BALANCE SHEET.”

    This is a highly disingenuous comment. Bigness is relative. The magnitude of bigness we have now is only necessary to create the appearance of liquidity in a suckers’ market for non-transparent instruments, which is exactly what these banks want to do and exactly what we should not let them do.

  6. It kills me to say it (because I think it’s a sad commentary on our country’s government) but I agree with Nemo 100%. If Nemo doesn’t mind I’ll eat a hat with him if we can wash it down with beers.

  7. I do not think the syndicate argument is very useful here. Just because a syndicate is involved does not mean any kind of institution can participate meaningfully in large transactions.

    That said, TBTF institutions cannot be regulated into good behavior. The TBTF institutions have captured their regulators and the policymakers that determine the architecture of regulatory institutions.

    But even if that were not the case, regulating TBTF institutions is a catch-22. You can’t fine a TBTF institution any amount larger than what can be shrugged off as a mere cost of doing business. Any real threat to their business models, as they wish to do business, will be mutually destructive by definition.

    I do not think we can credibly write off breaking up the banks as something that will be easy, however. It won’t be, and there will likely be an ugly transition. But we’ve made some bad decisions about the kind of economy we want to have, such that major sacrifices will be necessary to save our empire.

  8. It’s hard for leaders in the government (and the government/big business coalition) to give up on the big financial institutions because of the huge rise in importance of the financial sector to our economy over the past 25 years. As manufacturing has been been devalued in this country and been replaced by the financial industry, the results have been huge profits for the investor class, which was the intent of the Republican economic strategy all along (re: the ease of the tax burden on capital gains, the wealthy and inheritance to stimulate such investment and the lessening of regulation in the energy and financial fields.)

    The fear is that by breaking up the big banks and re-establishing (and actually enforcing) regulations, the growth of that very lucrative industry could be catastrophic for this country. This is part of the reason that the Clinton administration followed the Reagan/Bush line of economic thinking.

    Basically we find ourselves now in November with no changes in regulatory practices (other than a “Pay Czar) and a government leaning on the big financials to lead the way out of the economic crisis we are in.

  9. I imagine most people (say yourself for example) who make their income from derivatives would agree with you that big banks can’t be regulated into good behavior. How genuine and sincere they are in their statements is anyone’s guess.

  10. Ted, don’t fret about your country’s government (assuming you refer to America) because there’s a whole group of them. Well at least one prime partner-in-crime, namely Britain. Remember where AIG’s OTC Derivatives office was – London!
    I have my hat stewing as we speak!

  11. It is probably worth separating the arguments for economies of scale in investment banking and commercial banking; as I would hope both Citi’s experience as a universal bank and GS’s refusal to use its banking charter for, well, banking make clear, there are no economies of scope.

    On the investment banking side, there is a minimum efficient scale roughly around the size of the late Bear Stearns – big enough to have a full suite of products and a credible position in London, NY, and HK. Additional size beyond this confers no inherent advantage – you could as well have a bigger collection of poor performers (ML) or a bigger collection of better performers (GS). If you go smaller – say, Lazard size – you lose the ability to compete in capital markets activities. But no one proposes breaking up any firm into pieces that small.

    On the commercial banking side, there are meaningful economies of scale most of the way through the size curve; unlike an investment bank, overhead does not grow in proportion to size. Every one of the dozen or so mergers that created BAC really did deliver cost savings, and these savings really would be unwound if all of the Nations components came back out.

    The issue is that these savings are minor compared with the risk the large institutions pose to the economy. By all means, acknowledge the costs in redundant overhead – but compare those hundreds of millions with the hundreds of billions (more honestly, trillions) in intervention needed when the giants break down.

  12. Could it be the nice guy from Dillon, South Carolina forgot all the valuable lessons that Philip and Jonas taught him in the family owned drugstore?? A lot of important lessons in the scrolls about interest and usury. Let’s hope Bernanke doesn’t forget those valuable lessons as he wades through the torrent. Or we may have to make his theme song “I Ain’t No Nice Guy” (Afterall)

  13. At some point the virtues of economies of scale run into diminishing returns precisely at the point where reduced competition fosters complacency, as I’ve been arguing recently, in consonance with Mr. Johnson’s views, on my blog.

  14. Having his boyhood home foreclosed upon should have should have been his wake-up call that he forgot his roots.

    And to whomever flagged my post – wake up and stand up to these morons, they are tanking our economy and our country – and you flag my post??????

  15. I don’t think breaking up the banks is a good thing. We need to go back to prohibiting the banks from operating as investment house and vice versa. We need to limit these institutions from being insanely leveraged on cheap money.
    The only way to improve the banking system is to bring responsibility back by having strict lending policies in place.

  16. Ray said: ¨The fear is that by breaking up the big banks and re-establishing (and actually enforcing) regulations, the growth of that very lucrative industry could be catastrophic for this country.¨

    This refers to the financialization of the country. In 2007, 40% of the S&P-500 profits was from financial ´services´ firms and people´s self-esteem was reduced to a 3-digit score. THAT is catastrophic for this country!

    If you really think about it, then you have to conclude that the financial ´services´ firms have not delivered useful services. You call it an industry. It is not. It does not produce anything useful.

    Just consider CDS. Naked CDS are like a fire insurance on someone else´s house, or like a life-insurance on someone else, prohibited in many countries, just not in USA. Non-naked CDS also is without merit. S. Das, an expert on CDS, has shown that if they really were used as an insurance for an underlying bond, than the insurance fee would be too expensive to make sense.
    Or consider other derivatives, like hedges against oil price swings. First, we have ´services´ firms like GS, contributing to oil price speculation, and then real industries can buy insurance, from those same firms, against oil price increases. Research has uncovered that there are 27 speculators for every oil consuming/producing trader. We should prohibit speculation on the futures market. Oil going from $150 to $ 30 within a year! Crazy! How can e.g. an airline company deal with this madness?!
    Or consider the $ 500 million Harvard endowment had to pay to GS for canceling an interest rate swap on $ 1,1000 million gone wrong!
    Or the revelations of all the municipalities and pension funds now stuck with CDO´s squared and other obscure nonsense.

    Ray, over the last 25 years, the financial ´services´ firms have lobbied for unlimited experimentation with their innovations. The experiment has gone horribly wrong. So let´s unwind those derivatives and get rid of them. The disadvantages clearly outweigh any advantage.

    Undoubtedly, you have seen graphs showing income and wealth distribution in this country over the last 100 years. The inequality has never been so great. It even tops the previous top at the end of the roaring twenties. This inequality is now killing people (e.g. 44,000 people die every year because of health insurance failures). The inequality, due to the financialization of the country, is now 1% top ´earners´ taking 25% of the total income; and 90% of the wealth is in the hands of the top 1%. THAT is catastrophic for this country!

  17. All this academic nonsense is so tiresome. The large banks have successful poisoned the entire financial market by hiding risk, making the financial condition of every corporation a mystery, looting the tax system and enriching a handful executives and immiserating everyone else. They have accomplished nothing else except perhaps aiding and abetting a takeover of our economy by the Chinese and putting us on the road to Argentina. I don’t understand all this on the one hand, but on the other hand, temporizing. When will you people cut to the chase?

  18. +100, Ray, with one qualification. You write:

    the Republican economic strategy

    but isn’t it more appropriate to write:

    the ruling elite economic strategy

    After all, both parties have been part of the same system since the mid-1970s at least, when the policy decisions to financialize the economy seem to have been taken.

  19. I have seen the evidence that shows the unprecedented gap in wealth in this country, a gap nurtured by the economic agenda of the Republican party. The policies of the Reagan administration have led directly to this crisis we are in. While we can point the finger at Reagan, both Bushes, Phil Gramm and his wife, Wendy, we also have to include Lawrence Sanders and Robert Rubin from the Clinton (and now Obama) administrations. All are culpable in the deregulation schemes that have given us banks to big to fail and completely unregulated derivatives.

    Unfortunately, President Obama seems to have fallen into the pro-financial industry camp and isn’t moving to do anything to solve the root cause of the problem.

  20. Lambert, you are correct and I just posted an answer to Carol that includes the Clinton administration as architects of our current crisis. Lawrence Summers and Robert Rubin guided the Clinton administrations economic policies and they both fought attempts to regulate the financial sector.

    However, I stand by my statement that it is the Republican economic strategy that they are following.

  21. I know that this is off topic, but I can see that you are a thoughtful, data driven thinker. Before you promote the data regarding “44,000 dying every year…”, I would like to direct you to the actual study for your review.

    Click to access health-insurance-and-mortality-in-US-adults.pdf

    How do you weigh these comments by the co-lead Harvard researcher,Dr. Steffie Woodlander : “The data from the National Center for Health Statistics assessed health insurance at a single point in time and did not validate self-reported insurance status.” “We were unable to measure the effect of gaining or losing coverage after the interview.” Pay special attention to the time line.
    Two of the lead researchers are members of Physicians for a National Health Program ( which is a research and educational organization of 17,000 doctors who support single-payer national health insurance.

  22. The basic problem with this thinking is that the financial sector produces nothing – except risk and enrichment for individuals at the top. Finance should be the handmaiden of industry, small business and innovation, not the opposite. Unless we have a broad-based economy, our economy is not sustainable. If Bernanke (and Summers and Geithner) have their way, we will continue to see taxpayers’ money at risk in the TBTF casino. And, if global warming comes to pass, we may be watching our country turn into the largest banana republic in history.

  23. Bond Girl is really good on Catch 22s and whoever doesn’t catch that is double-bind-blind
    – probably one must have lived (nd suffered) in them, have experienced this feeling of being shackled hand and foot to be able to figure out where they’ll most likely to next crop up.

  24. Jessica,
    indeed off topic, but I do appreciate your comment. I was a little bit suspicious re the timing of the study release (at the height of the debate), but with hardly any time left after following the ongoing financial horror story, and reading the study came out of Harvard Medical School, I did not check the report.

    Thanks for the link to the factcheck website: ¨Now, on to the tough question: Is the 45,000 figure accurate? We can’t say for sure, but scores of other studies also conclude that persons without health insurance have a higher chance of dying prematurely than those with health insurance.¨

    Indeed, the 45,000 number is by far the highest of the numbers mentioned from other studies, but what remains it that involuntary uninsurance is a cause of death, and other studies conclude 13,000 premature deaths per year (ages 55-64) or 18,000 (ages 25-64).

  25. Diane, I think we actually came close to being a banana republic after the 2000 election. Think about it; we had a very controversial election that was only decided after a partisan supreme court decision, our economic policy was tilted lopsidedly in favor of the very wealthy at the expense of middle class and we came the closest we have ever come to becoming a police state after being attacked by terrorists.

    Back on topic, though. Our economy is not sustainable as it is because it is based on debt. I’m not talking about government debt, but individual debt. Specifically, the debt incurred by the middle class as they try to keep their standard of living while losing purchasing power to inflation, taxes and salary stagnation (look at the records indicating the shrinking amount of household savings over the past 25 years, until this crisis hit, anyway.) As the middle class is by far the largest segment of our population, we count on it to keep our economy going. When well paying manufacturing jobs were being lost and replaced by less well paying service industry jobs, credit became even more important to the economy, thus the financial sector grew. The problem was that eventually people came to the point of not being able to pay their credit bills and loans became riskier. The financial services had to find a way to spread that risk around to keep the economy going. One result was derivatives, which not only spread the risk, but proved so difficult to track and understand that few in the financial industry itself knew what was going on. Another result was adustable rate mortgages and interest only loans, both created to allow an increasingly debt ridden middle class to keep buying houses and thus keeping the housing bubble going.

    Unfortunately, we have the champions of the financial industry now tasked with cleaning up the mess while keeping very lucrative (to a vew, anyway) financial sector intact.

  26. Tough cookies? :) Maybe there is a gender war underway as the world struggles to find a new paradigm. The women and the feminist (and yes men too can be feminist) against the old boys club. Let me see… Brooksley Born, Elizabeth Warren … and now Neelie Croes and …

  27. hmmmmmm

    Some of those large pension funds might regret they did not lend their billions to Muhammad Yunis (10% interest 1% default rate) rather than entrust their savings with zombies in the shadow banking system.

    Paradigm shift?

  28. I agree with everything you’ve said, Ray, but I still strongly believe that a sustainable economy must include things like manufacturing, agriculture, technology, innovation, small businesses, etc., as well as a robust financial sector that invests in these things. It seems as though the financial sector has simply become a huge casino, where bets are made on thin air, rather than the investment tool it should be.

  29. Bernie has never had a real job and only knows what has been written by others.

    However, it did not take him long to learn from greenspan to do just what the financial mafia tells you to do.

  30. “Bernanke ..stays carefully on the sidelines” ; Maybe that’s because he Walks a Political Tightrope:

    Technically, the Fed is an independent body, but soon a majority of the seven Federal Reserve Board members will be democratic appointees.The Federal Reserve , whose responsibilities include monetary policy, financial regulation, and consumer protection, is run by the seven members of the Board of Governors. The members are appointed by the President, subject to Senate confirmation. The following lists the current status of Board members:

    Federal Reserve Board Members Term Expires

    Bernanke Chairman 2020
    Term as Chairman expires January 2010
    Kohn Vice-Chairman 2016
    Term as Vice-Chair expires June 2010
    Duke 2011
    Tarullo Democratic appointee 2022
    Warsh 2018

  31. It seems to me that Bernanke has gone beyond what was necesaary to prevent a worse economic problem and continues to do os. If he said something inconsistent with that would if matter?

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