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Too big to fail or too big to manage?

“Too big to fail” is the moral hazard conundrum at the centre of the debate about the future of financial services, anchoring issues such as how the sector should be structured, regulated, financed. More than two dozen global banking behemoths have been officially designated too-big-to-fail or in regulator-speak “globally systemically important banks”.

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The issue is – and of course it doesn’t just apply to banks – some institutions can be so inextricably woven into the fabric of an economy that it is cheaper for taxpayers to support them than wear the consequences of their failure.

"This issue of “too big to manage” started to come to the attention of markets before the crisis."
Andrew Cornell, Managing Editor

Size is fundamental. No Australian banks and relatively few in Asia are GSIBS – yet institutions can be big enough in particular markets to be “DSIBS”, domestically significant and potentially too big to fail.

For the G20 and its regulatory agency the Financial Stability Board, this live issue revolves around prudential standards and supervision. Hence the focus on capital levels, liquidity, leverage ratios and other mechanisms of loss absorption.

Yet behind this crucial debate is a deeper question: why have these institutions become so big? The obvious answer is the classic one of economies of scale. Meanwhile, another live debate in the wake of the financial crisis is size not only creates scale but being TBTF in itself has advantages. Providers of funding make it available more cheaply because they believe governments will not let the institutions fail.

The ratings agency have made this explicit, noting any lowering of the implicit guarantee governments offer would result in lower credit ratings.

But is that the only role investors are playing?

Historically, both debt and equity investors have supported larger institutions for reasons that essentially boil down to access to cheaper funding, economies of scale and less likelihood of failure.

These attractions have overwhelmed so-called diseconomies of scale, the disadvantages of being big.

It is this downside to scale which now appears to be receiving a lot more attention.

In recent weeks we have seen another rash of global banking scandals and the defence, made explicitly in some cases, is no chief executive or board can reasonably be expected to be across the minutiae of organisations employing hundreds of thousands of people in hundreds of countries.

In testimony in Britain, HSBC chief executive Stuart Gulliver asked “can I know what every one of 257,000 people is doing — clearly I can’t. If you want to ask the question could it ever happen again — that is not reasonable.”

Well, exactly.

This issue of “too big to manage” started to come to the attention of markets before the crisis.

Institutional complexity grew in synergy with ever more complex financial and shadow banking systems in the run-up to the crisis. For example, Citigroup, before it became a ward of the state during the crisis, was increasingly suffering from what many believed was unmanageable complexity.

It was fined for ramping bond markets in Europe, banned from some businesses in Japan, and pilloried for its analysts flogging stocks they considered dogs in the US. Then chief executive Chuck Prince acknowledged his biggest challenge was to institute a common, effective culture and maintain proper controls across the sprawling global empire.

It was this issue of size and complexity Reserve Bank of Australia governor Glenn Stevens presciently addressed in his Shann Memorial Lecture in 2011.

"[New] arrangements surely have to include allowing badly run institutions to fail, which must in turn have implications for how large and complex they are allowed to become," he said. "The finance industry, certainly at the level of the very large internationally active institutions, needs to seek to be less exciting, less ambitious for growth, less complex, more conscious of risk and more responsible about where those risks end up than we saw for the past decade or two."

Since then the downside of size and complexity have become all too clear – and costly for banks.

Roger McCormick, a law professor at the London School of Economics and Political Science, a few years ago began totalling the penalties being imposed on the largest western banks. What started as a one-off project has become ongoing.

Indeed McCormick has now formed an organisation dedicated to the task. The CCP Research Foundation is a social enterprise which claims no political affiliations.

“As a Community Interest Company, it will seek to support academic and civil society research projects. The Foundation is a result of (and inspired by) experience gained in the management of the Conduct Costs Project at the London School of Economics.”

McCormick had been stunned by the scale and seeming relentlessness of penalties imposed on the large global banks for misconduct.

His team published a report which showed by late 2013 the top 10 banks had paid £100 billion in fines since 2008. The offences included money laundering, rate-rigging, sanctions-busting and mis-selling securities like subprime mortgages and bonds.

One American bank alone had paid £39bn by the end of 2013. By the end of 2014 penalties will likely have doubled.

At the heart of many of the transgressions, if not all, were bad apples, individuals or businesses ignoring not only ethical standards but often explicit requirements of their employer. The trouble was, the barrels were so big and the numbers of bad apples so dispersed it would have been a risk to buy the barrel at all.

And that’s where investors come in.

The size of the fines being tracked by McCormick and others and their relation to size and complexity means investors increasingly will have to price in what is known as “operational risk”. Investors already assess credit and market risk, they study bad debt charges and watch lists, build models of credit quality, run proxies for the market risks banks run.

Now though they will have to think of models for op risk – because the size of fines is so great. What will be behind those models? Size and complexity must surely be red flags. It is not just the balance sheet and the loan book which need to be analysed.

At the very least, there will be questions about whether large, complex banks should be carrying reserves similar to the provisions they have for loans going bad.

There is an interesting parallel here with work being done on the optimal size of companies. Along with economies of scale like buying power and risk diversification, larger companies had information advantages – not just in the information they accessed but how they managed and processed it.

With modern technology, computing power, the cloud, the internet of things, that advantage is disappearing. Moreover, there is an established body of research demonstrating size works against innovation.

Governments and regulators are tackling TBTF with direct measures but also ones – such as higher capital - which make it more expensive for some bank models to operate. This is also where investors come in: expensive banking models don’t deliver the best returns.

We are now moving into the next phase of the post-crisis reconstruction of the financial universe. Regulatory costs, implicit and explicit, are too high for investors to ignore.

This may be the long forecast end of the global, universal banking model. Certainly some are making that argument, building structures that may be cross-border or multi-business but won’t be the size and complexity of what has gone before.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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