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Let Customers — Not Regulators — Decide the Right Size for Banks

To see why it's absurd for Washington to be debating how big the country's banks should be, imagine the following scenario:

You leave your hometown after high school to study and later work abroad for several years. After some time, you decide it's time to come home, at which point you reacquaint yourself with your high school prom date, who never left. You decide to get married. After the honeymoon, it's time to pay the bills, which means you have to choose how to bank. Your spouse has banked for years at a local small bank because of the personalized service it offers. It has only a few branches. But having moved around, you think fondly about all those times you found a bank branch during your travels and you appreciate that you didn't have to close your account just because you moved to a different part of the state, let alone an entirely different state, or even abroad.

What's the right way to go? That's for you and your spouse to decide. The decision should not involve politicians and regulators.

Small banks may make more sense for people who seldom travel or relocate, or who use a limited range of services. Big banks may be preferable for people who move around more often or use a wider range of services even with the advent of automated teller machines and telephone, online and now mobile banking. The best way forward is to let people vote with their feet, allowing banks to compete to offer the best service.

That this debate arises in the political realm reflects what has always been wrong with the U.S. approach to banking politics and regulations, ever since Thomas Jefferson as an anti-Federalist defending agrarian interests challenged Alexander Hamilton's Federalist vision of an urbanized America with bank-financed industrialization. Author Ron Chernow makes that point in his fabulous Hamilton biography. Two centuries on, the story hasn't changed much: "Jeffersonians" want lots of small banks, while "Hamiltonians" see nothing wrong with allowing some banks to get big.

Professors Charles Calomiris and Stephen Haber at Columbia and Stanford respectively, in their recent book "Fragile by Design," detail how populists and small banks in the United States historically colluded in the political sphere to prevent banks from getting too big. And now we have the Dodd-Frank Act, which through an evolving body of regulations seems intended to encourage shrinkage, though it may also as an unintended consequence work to the detriment of small banks (as my colleagues Hester Peirce, Ian Robinson and Thomas Stratmann have shown with research on how small banks are faring under Dodd-Frank).

To be fair to the politicians and regulators involved in designing and implementing Dodd Frank, the issue of bank size ties in closely to the complexity of a bank's activities, because some complex activities like structuring collateralized debt obligations lay at the heart of the recent crisis. Since the repeal of Glass Steagall through the Gramm Leach Bliley Act in 1999, some big commercial banks have greatly increased their use of complex off (bank) balance sheet activities to engage in transactions that were previously the sole province of investment banks.

Interest in such activities reflects the fact that as accounting rules, banking regulations and tax laws become more complicated, so have the ways of getting around the rules. But complexity and bank size are two separate issues. This is why some regional banks, like PNC, can credibly challenge the "systemically important financial institution" or "SIFI" designation, on the grounds that they were not involved in the recent crisis.

To address complexity, how about simplifying banking regulations by simply raising capital requirements even more, as many advocate in various forms? Likewise, to address size, how about letting customers decide how big their banks should be?

Many U.S. politicians, regulators, populists and small bankers want to convince us we should fear big banks. After four years, it seems the bigger concern lies with the regulatory burden made worse by Dodd Frank. That's because to the extent that it greatly increases the cost of banking those costs will be passed on to the customers in the form of fewer services, fewer branches, higher fees, and overall, even more customer dissatisfaction.

Stephen Matteo Miller is a financial markets scholar and member of the Financial Markets Working Group with the Mercatus Center at George Mason University.


(9) Comments



Comments (9)
The concentration of deposits within only three banks is a big potential problem for the U.S. economy. Seventy percent of deposits are concentrated in three entities. To manage the burden of risk the U.S. government has increased regulatory costs (i.e. Dodd-Frank) in order to try to mitigate its credit risk. Why does the US government have this concentration risk? The deposit insurance increased from $10,000 to the present $250,000 notional value. As a consequence, the concentration risk has also increased. Most depositors believe the assumed notional value is even higher, over $1 million. To the sophisticated reader this derivative put given freely to depositors via the FDIC to the financial entity encourages depositors to concentrate their funds within one financial institution. To decrease concentration risk and make use of Modern portfolio theory (MPT) the US government should reduce the put notional amount gradually down to $50,000. More financial institutions would gain market share and therefore the concentration risk can be reduced which would also reduce the need for non-revenue producing costs imposed by excessive regulation.
Posted by tburke79 | Monday, August 25 2014 at 9:44PM ET
YES! Finally an article by somebody who gets the point that the source of America's strength is our free market system. The only point of disagreement I have with the author is that he advocates increasing capital ratios as a solution. The real solution is to eliminate the moral hazards of deposit insurance and bailouts, and let the customers decide how the banking industry should restructure itself. They will vote with their money - as it should be. Let's eliminate deposit insurance and most regulation, with a three-year sunset period to allow the industry time to restructure itself. Then billions of dollars of waste disappear, thousands of bureaucrats have to get real jobs, and risks are taken at the shareholders' expense.
Posted by Bob Newton | Friday, August 22 2014 at 9:29PM ET
I am a libertarian. I generally agree with the premise of the author to let the market, let the people, the customers decide the size, etc. of banks as well as the risks they take. However, if you really want the market to decide, like I do, you then also need to support the government intervention into deposit insurance (FDIC). If the taxpayer is on the hook (yes, they are even though we banks have completely funded the FDIC with private premiums, there is the taxpayer guaranty to the FDIC)then the taxpayer (federal regulators) make the rules. That simple.

Still, back to the author's let the market and customers decide....she certainly is not a supporter of large banks because the market did decide already...they ran from MS, Citi, GS, Lehman and all the MMMF's. All were illiquid and would have taken bankruptcy, and none had a positive new worth if resolved back then. The market spoke. So, the author, if her wish comes true, will have the ability to watch the big banks disappear. Only a fool, and America is littered with them, would trust the real large banks with anything.
Posted by countrybanker | Friday, August 22 2014 at 11:06AM ET
I would generally agree with the argument that customers should decide. It is the right orientation in today's economy. The problem, however, with applying exclusively this principle in the case of banking, and given the inevitability of TBTF is that customers are not the only stakeholders when a bank fails: taxpayers become the primary ones. This is why we can't keep government out of the decision. Another basic principle of economic efficiency, as I am sure Mr. Miller knows far better than I, is to try to internalize all the real costs of economic activity. Unfortunately customers, shareholders and executives are easily able to externalize much of the real costs of their activity when they have the moral hazard of deposit insurance and government bailouts. Now if we could eliminate TBTF this might be different. But if one thinks this will happen in today's environment then let's put Santa in charge of the Fed.
Posted by Lawrence Baxter | Friday, August 22 2014 at 10:44AM ET
Banks grow by mergers and acquisitions. That traps people in larger banks without their will. Now the five largest banks hold nearly half of deposits. Moving out of a TBTF bank is very difficult, especially for users of on-line banking. Inertia holds people in place.

This is the market the author is talking about. The economists sterile models don't capture any of the practical aspects of customer choice.
Posted by Ed Walker | Friday, August 22 2014 at 10:27AM ET
Most people should have more than one account. The small town bank or credit union with personalized service and affordable interest rates. And a larger international/worldwide option for traveling abroad.

I definitely believe that larger banks need to somehow be regulated. They need to separate there investments from banking. There needs to be transparent accounting practices, internal and external audits and investigations. Why have no "Bank Officer's" who caused corruption and the world's economic instability have been charged?

I would also like to see a "Government" run bank that is funded by the people and serves the people, because we all know damn well that the banks are not in business to service people or customers/ They are in business to cause mischief and malice across the world.
Posted by Intelligence Ratio | Friday, August 22 2014 at 5:18AM ET
I don't know, but around 80,000 *former* homeowners would disagree with the PNC claim that they were not involved in the recent crisis. Mr. Demchak, the current CEO, helped invent those CDO gadgets before heading to the green hills of Pennsylvania. And Mr. Rohr didn't just find that $35 million golden parachute under the Christmas tree. It's was woven with the life savings of many former PNC customers. Yeah, let's just let the market decide this one. That'll work out, yeah. Uh-huh.
Posted by teknoscribe | Thursday, August 21 2014 at 9:45PM ET
I think I probably agree with you that Hamilton wouldn't be happy if he saw what's happening today. But, I'd leave that to the Hamilton experts like Ron Chernow and Richard Sylla to decide. In any case, that's why I used "Hamiltonians" to distinguish from Hamilton. By that I just meant, anyone who doesn't side with the "Jeffersonians," who in my view are the real trouble makers in this story.
Posted by StephMiller | Thursday, August 21 2014 at 2:45PM ET
I find it disgusting and highly offensive that you invoke Alexander Hamilton to justify your argument in defense of today's mega-banks. Hamilton conceived of the banking system as a vehicle to promote the progress of the nation through investments in production and infrastructure. He fought for a national bank, not an oligarchy of private banks. He would be absolutely horrified at the system that currently prevails, where gigantic banks are too busy gambling with derivatives to invest in anything useful, and are being rewarded by the taxpayer for doing so.

It is true that Dodd-Frank is a disaster. That was entirely foreseeable, because Dodd-Frank was drafted by two of Wall Street's most devoted courtesans, for the purpose of heading off the only solution that will actually work -- the restoration of the original Glass-Steagall Act.
Posted by Macwhirr | Thursday, August 21 2014 at 12:30PM ET
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