If they tell you often enough that "systemic risk" is caused by the "too big to fail" institutions, maybe you'll believe it. I never will.
The failure of the banking system in 1932 was not caused by a few big banks.
A very large number of smaller banks followed similar strategies and took similar risks — and hence became illiquid and insolvent at around the same time. Not every small bank in the country was involved but far too many of them were for the system to survive.
It's a lot quicker and surer to take over and keep operating a small number of large institutions than a large number of small ones.
Systematic risk can be diminished if industry concentration is increased — fewer and larger banks. However, if there are many small banks and they follow diverse asset and business strategies, then the risk can be reduced.
Several times from 2004-2007, I spoke with an executive who had created a wholesale mortgage unit within a sizeable institution. After four years, he was making more profit than all 1,500 of this institution's branches. He didn't see himself as a risk taker, nor did his bosses.
Mostly the mortgages he bought or originated through brokers were 2-28s or 3-27s, on which the payments would rise dramatically in two or three years. I asked him what would happen if the borrowers couldn't make the increased payments. "The value of the home has gone up, and they can either refi or sell."
"What if home prices go down?"
"That hasn't happened in decades. We are diversified. If home prices ever went down, a lot of people would be in big trouble, starting with the GSEs." Indeed, his greatest fear was that with continued prosperity, the government-sponsored enterprises would move further into his market and curtail his growth — which is what they had already begun to do.
Today, the business he started has high negative net worth and the owner would sell it if there were anyone to buy it. He is long gone. (This is in the spirit of the false, fatuous and oft-repeated assertion that "Just a few people made this happen — and they are all gone now.")
This man's business was not nearly large enough to generate systemic risk, and in fact the bank that owns it did not fail. But many others, big and small, saw the same "opportunity" that he did and adopted similar business models at about the same time, up and down the feeding chain.
If we had only small banks, then the problems could have been more severe and intractable, because there is no effective way to supervise or absorb large numbers of failed domestic institutions. Furthermore, the massive and expensive financial marketing structures we created were capable of spraying bad asset strategies all the way out to Iceland and Ireland, ultimately endangering the worldwide economic system.
Besides the comfort of groupthink and the power of massive financial merchandising in a context of artificially low interest rates, there is another fundamental reason for small as well as large players to be drawn to the same magnet: corporate and business unit performance is principally evaluated, not on an absolute basis, but relative to similar enterprises. Hence, it is actually perceived as "less risky" to take the same risks your competitors are taking than to avoid taking these risks.
For instance, in 1987, 2000 and at several other times, a minority feared that the sky was falling, But it was clear to bankers that most competitors would not trim their sails drastically.
The minority, who markedly reduced their risk exposures, performed badly relative to competition — which is an extremely disagreeable result if your rewards or job depend on doing at least as well as your competitors. Why take that chance?
The participants in these risk-spreading movements behave, not like lemmings, but like steel filings attracted when current flows into the electromagnet and the particles are magnetized. Larger particles are less likely to be moved very far.
It would be heartening and indeed salutary to hear less about "too big to fail" and more about the need to recognize and address risks that run across the aggregate balance sheets and income statements of the financial industry, including big banks and small.
These risks are easy to identify. They relate to leverage and to concentration in asset classes and related financial contracts that have not stood the test of time. An example of such an asset class: the "modern" types of residential mortgages, which were leveraged and piled up in the pipeline pending distribution.
