Spero Consulting

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.