Today’s (September 30) Wall Street Journal contains a front-page article, Industry Is Remade in a Wave of Mergers, which reports that the three largest banks now control over 30% of the nation’s deposits.
We’re writing because we take issue with the paper edition’s blurb: “For the economy and government officials, the very size of these banks means they should be better insulated from big shocks…” In our mind, there seems to be an implicit, but unjustified, diversification-benefit argument behind such statements.
We see no evidence that massive size has insulated any financial firm in this current crisis or any previous crisis in this country or any other country. In fact, we argue that the opposite is quite possibly true.
As we’ve written in the past, e.g., two weeks ago Forced Mergers? Bigger Is Not Necessarily Better! and reiterated Sunday in What Will Wachovia’s Presumed Demise Mean for B of A?, permitting centralization (of asset allocation) into the hands of fewer and fewer individuals creates its own systematic risk. Each senior decision-maker’s idiosyncratic (and possibly irrational) beliefs and judgments affect a larger and larger share of the economy’s resource decisions, and that can’t be a good thing. Thus, there is a trade-off of the cost savings (of consolidation) versus the additional risk of such centralized decisions.
Such idiosyncrasies go beyond any single individual and include organizational factors, as well. For example they include the behaviors both consciously and unconsciously induced by control schemes, including performance measures and reward schemes; culture and ethics; history; and even modeling techniques and assumptions. All of these together create a firm-specific, idiosyncratic component to the probability of income and losses being realized, which could amplify variability and the probability or magnitude of bad outcomes.
When we have the time, we’ll try to graph an example of an efficient frontier as the number of firms shrink. It is not simply the consolidation of past (or prospective) uncorrelated positions, which on average would produce realized diversification benefits, e.g., higher low outcomes. Instead, unlike much of traditional financial theory, which assumes certain distributions and completely rational decision-makers, it is easy to imagine someone’s past successes unduly influencing their decision-making and creating a concentration of risk within a particular industry, region, or asset class. Perhaps Wachovia and mortgages is a good example of this behavior?
The second part of the blurb, which we did not reproduce, contains a “too big to fail” statement, and the writers correctly note that this mentality intensifies moral hazard problems by providing a perceived limited liability on the loss side, thus making such institutions more likely to take risks and get into trouble. That’s not our argument, but it does exacerbate the issue that we’ve identified.
