Saturday, October 29, 2011

Big Banks

Published October 29, 2011
The case against scale in Wall Street
Breaking up big global banks, curbing their growth beyond a certain size would be a sensible demand


'FROM Seattle to Sydney, protesters have taken to the streets. Whether they are inspired by the Occupy Wall Street movement in New York or by the indignados in Madrid, they burn with dissatisfaction about the state of the economy, about the unfair way that the poor are paying for the sins of rich bankers, and in some cases about capitalism itself,' this was how The Economist began its editorial on 'Capitalism and its critics - Rage against the machine'.


Excesses of the financial sector manifest themselves in a variety of ways: in how powerful these institutions have become, in the systemic risk they pose to the global economy, in the monetary rewards they appropriate for themselves
'In the past it was easy for Western politicians and economic liberals to dismiss such outpourings of fury as a misguided fringe. In Seattle, for instance, the last big protests (against the World Trade Organization, in 1999) looked mindless. If they had a goal, it was selfish - an attempt to impoverish the emerging world through protectionism. This time too, some things are familiar: the odd bit of violence, a lot of incoherent ranting and plenty of inconsistency. The protesters have different aims in different countries. Higher taxes for the rich and a loathing of financiers is the closest thing to a common denominator, though in America, polls show that popular rage against government eclipses that against Wall Street.'
I read this article in the wee hours of the morning, on one of those nights when sleep eluded me. So the current protesters have no coherent demand, as opposed to the 'mindless' goal of the demonstrators who staged protests against the World Trade Organization (WTO) in Seattle in 1999.

What would be a good demand for these protesters, I thought to myself.

To get to that, first, we have to decide what are some of the problems the world is facing now, and what are some of the complaints of the masses.
To me, one big problem is the stubbornly high unemployment rate. In the US, unemployment remains close to 10 per cent. The rate is higher among younger people. In America 17.1 per cent of those below 25 are out of work. Across the European Union, youth unemployment averages 20.9 per cent. In Spain, it is a staggering 46.2 per cent.

Two, the excesses of the financial sector. The excesses manifest themselves in a variety of ways: in how powerful these institutions have become, in the systemic risk they pose to the global economy, in the monetary rewards they appropriate for themselves. Their size, and the phenomenon of 'too big to fail', have created moral hazard among the bankers, which has led to a ludicrous situation where gains are privatised, and the losses are socialised, as Nassem Taleb, the author of The Black Swan puts it.

Three, because of the huge amounts of money controlled by a few global institutions, these big players are able to move their funds around the world at a click of a button and cause significant volatility to global asset prices. Plunges of 20-30 per cent in asset prices are no longer an outlier event. This has spooked retail investors away from the market, leaving the global financial markets the playground of a select few.

Four, behavioural psychologists have identified humans' tendency to anchor. It has been documented that when people make quantitative estimates, their estimates may be heavily influenced by previous values of the item. For example, it is not an accident that a used car salesman always starts negotiating with a high price and then works down. The salesman is trying to get the consumer anchored on the high price so that when he offers a lower price, the consumer will estimate that the lower price represents a good value.

So by the same token, say, for a trader who generates a profit of $1 million or $2 million a year for the company, a compensation of say $100,000 to $200,000 may be deemed fair. But if the same trader were to be given funds of $10 billion to trade, he will most certainly sniff at a compensation of $100,000 or $200,000 a year.

So in other words, the concentration of funds in a few big global institutions has allowed for these bankers to demand humongous bonuses.
So in my view, a sensible demand of the Occupy Wall Street protesters would be for the world to break up the big global banks, and curb their growth beyond a certain size. This can be made into an agenda at the WTO. While in its current form, the WTO negotiations revolve around getting countries to agree to dismantle trade barriers such as subsidies, tariffs, quotas etc, an added new agenda could be to get countries to agree to curb the size of their banks and financial institutions.

What would be some of the benefits of such a development?
One, employment can be created. Instead of x number of economists, accountants, risk managers each working for just three big banks in the country, by breaking up the banks into, say, 30 smaller ones, the requirement for economists, accountants, risk managers and so forth would be greatly enhanced.

Two, breaking up the banks would eliminate much of the risks that the financial sector now poses to the global economy. The failure of any one bank would not threaten to bring down the global economy. Governments will not feel obliged to bail them out. Banks will be more responsible for their actions, they can go bankrupt, just like any other business if they are reckless in their decisions.

Three, with more participants come more varied views. Hopefully we will have less of a herd mentality. No one trade can move the market. Fund managers and traders have an incentive to seek out inefficiencies or mispricing in the market, instead of attempting to move the market by sheer bulk.

Shrinking bank bonuses
Four, bonuses for the bankers will shrink automatically.

Five, smaller institutions encourage more personalised service. This promotes a sense of community. Bankers may return to the days when they make recommendations based on what's good for their clients, not the con-the-customers-for-the-benefit-of-our-banks-and-our-bonuses mentality that, sadly, global banking has deteriorated into.

As for the size of the institutions, perhaps a good benchmark would be for the financial institutions to be no bigger than, say, 5 per cent of the GDP of the biggest country in the world. This would still allow banks from smaller countries to globalise and grow.

As I argued in my earlier column, on the whole, a larger number of smaller companies would result in lower profit margins and return on equity for companies. But on the flip side, more people could share in that profit pool. Also, we would create an ecology of myriad smaller companies that are likely to have more room to try new things and are less homogeneous in their thinking. Not at all a bad thing.



My Thots....

Moot Points.
The big word used by Basel is SIFI ---- Systemically  Important Financial Institutions.
But try, say applying it to the Sg context, and U would get a sense of the difficulties involved.
In Sg, try telling that to the Big 3, DBS, UOB and OCBC.
Will they agree to down size ?
Would it makes sense to have more banks, say breakup UOB back into UOB & OUB; breakup DBS into DBS & POSB and grant a bank license to HLF?

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