Reduce the risks of big banks by regulating them, not by breaking them up

28 June 2017

Big banks have appeared to be a risk to financial stability. But with big banks operating more efficiently than smaller ones, reducing the size of big banks is not the answer, says researcher Mark Dijkstra. Strict regulation is a better solution.

While regulators and supervisors are still preoccupied with how to prevent a crisis like the one in 2008, one lesson seems to be simple: never let banks grow so big that their bankruptcy can undermine financial stability. The financial system would have descended into chaos if big banks like Royal Bank of Scotland, Fortis/ABN Amro, ING, Wells Fargo and Bank of America had gone bankrupt. That is why the governments intervened by injecting huge amounts of capital into their major national banks in order to keep them running.

Too big to fail

It is remarkable that, since the crisis, individual banks as well as the financial sector as a whole, have continued to  grow. No notice seems to be taken of the knowledge that big banks are ‘too big to fail’ and have to be saved by governments when economic times get tough. Apparently, financial authorities prefer other policies to increase the resilience of the financial system.

‘Regulators should take into account that big banks operate more efficiently, thus generating more prosperity’, says Mark Dijkstra. In April 2017, Dijkstra completed his thesis on the relationship between big banks and economic prosperity. ‘The question whether big banks need to be broken up hinges on the trade-off between the social costs of saving big banks and the economic prosperity they generate.’ Dijkstra studied economics in Groningen and worked as a researcher at the Ministry of Economic Affairs and as an editor at Economische Statistische Berichten. He wrote his PhD thesis at the Amsterdam Business School (ABS) of the University of Amsterdam (UvA) under the supervision of Professor Arnoud Boot.

Non-efficient economies of scale

Dijkstra concludes that economies of scale of banks increase with their size. At the same time, however, economies of scale are either efficient or non-efficient, says Dijkstra: ‘Non-efficient economies of scale result from implicit government aid. Investors providing capital to banks are satisfied with a relatively small compensation. They anticipate that the government will always save a bank if its bankruptcy could jeopardize financial stability.’

As a consequence, the risks are transferred from big banks to government, and thus to the tax payers. An additional danger is that big banks will take more risks, which can increase the potential damage for the government. And even if a bank does not go bankrupt, there are costs that the government will have to bear, according to Dijkstra. ‘Buyers of government bonds know that the government bears the risks of a bank’s failure. They price in this risk and make governments pay higher interest rates on their bonds.’

According to Dijkstra, it is not easy to identify at which size a bank is ‘too big to fail’. ‘This depends on the kind of bank, the interdependence between the bank and the financial system and its position in a certain geographical area.’ Moody’s ratings underlie Dijkstra’s assessments of the benefits banks derive from implicit government aid. The credit assessment agency makes two distinct calculations of the risks of banks, one with, and one without implicit government aid. It turns out that larger banks have larger non-efficient economies of scale.

Efficient economies of scale

Efficient economies of scale are the result of larger banks’ lower production costs. ‘In the past, researchers believed that this was true up to a certain limit, but this has now proved incorrect, says Dijkstra who did research on the basis of 18,000 bank data between 2002 and 2011. In fact, the positive relationship between size and efficient economies of scale is becoming stronger as a result of technological progress. ‘Nowadays, banks incur only marginal extra cost when selling ten additional mortgages’, Dijkstra explains.

But this positive relationship between size and economies of scale is not always present, as is illustrated by the case of ABN Amro. Achieving economies of scale requires good management. According to Dijkstra, ABN Amro, which was one of the largest banks in the world in the years before 2008, was a patchwork of business entities. The management prioritised activities that were neither promising nor profitable and synergy between business units or countries was practically non-existent.

But on average, big banks are not so bad, Dijkstra believes: ‘When the positive and negative effects are cancelled out, the efficient economies of scale prevail. So, the overall prosperity grows in line with an increasing size of individual banks.’

Growth within rules

But that does not mean that banks should be allowed to grow unchecked. ‘The non-efficient economies of scale must be diminished’, says Dijkstra. This can be achieved by reducing the risks of bankruptcies or by transferring those risks to the banks’ lenders. ‘Since the crisis, the capital requirements for banks have been raised, but not very substantially’, says Dijkstra. The requirements include an increase of the quality of the banks’ capital to improve their capacity to absorb shocks. They also have to maintain more equity capital. In 2019, the equity capital of Dutch banks must be at least 4% of their total (unweighted) assets. Today the minimum requirement is 3%. ‘In terms of percentage this is a big rise, but in absolute terms it is not’, says Dijkstra.

That is why Dijkstra has more confidence in transferring the risks of a bail-out to lenders. ‘Under the current laws, lenders immediately have to write down 8% of their loans when a bank has to be saved by the government. As a consequence, they will be more conscious of the risks. Lenders will demand a higher compensation and banks will have to be more careful.’

And possibly, this kind of regulation is already having some effects. ‘Moody’s latest ratings suggest that big banks are benefiting less from implicit government aid than they used to do.’

More information? Email m.a.dijkstra@hotmail.com

By Bendert Zevenbergen

Published by  Economics and Business