Before we jump into banking, let’s start with a personal example. Say you make $50,000 per year. What are some of your biggest expenses?
You might rent an apartment. You might buy or lease a small sedan. You might buy a big flat screen television. There are plenty of other one off items you might purchase. But let’s keep these three in mind.
What happens if you suddenly get a huge raise, and now make $100,000 per year? How do your spending patterns change?
Do you now rent two apartments? Drive two cars? Watch two televisions?
No. You might move into a larger apartment. Drive a nicer car. Buy an even bigger, fancier television.
Your post-raise behavior makes a bunch of sense. Almost everyone would move in that direction. But if we focus only on redundancy, we can say you haven’t improved.
A big bank is not like a large group of small banks
Go back to the ridiculous first case, where you buy two of everything. If you have two cars, and one breaks down…you still have one to drive. If you have two apartments, and the water heater craps out in one, you have another apartment to use in the meantime. The same thing with your television.
If you used your pay raise to buy two of everything, you’d have some insurance against all kinds of risk. It wouldn’t be very exciting, since your backup items would rarely get used. It wouldn’t be as fun as having newer, nicer things. But you’d have a bit more protection.
The same thing happens in the world of banks. What happens when small banks get bigger?
a. Do they collect a larger volume of the same kind of assets?
b. Or do they move up the ladder, collecting bigger, fancier, more exotic assets they used to have?
As you’d expect, the answer is b. Big banks don’t look like a large group of small banks. And, for reasons we’ll soon cover, big banks don’t look like scaled-up versions of small banks. Big banks look like brand new institutions, separate and distinct from the other entities that fall under the “banking” umbrella.
Big banks are exposed to fundamentally different risks than small banks
I opened the post using your hypothetical pay raise as an example. When your salary doubles, you buy nicer versions of the things you already had. A nicer apartment. A nicer car. A nicer television.
Let’s return to the argument about redundancy. Nicer things don’t really help you in this regard. A more expensive car may be a little more reliable than a less expensive car. But not necessarily. Make and model have a bigger impact on reliability than sticker price.
Fortunately for you, when cars fail, they tend to fail in the same ways. A more expensive car has a similar composition to a less expensive car. The failure modes are predictable, and tend to appear with similar frequencies, regardless of sticker price. So buying nicer stuff doesn’t change your risk profile.
When it comes to bank assets, the same story does not apply. Big banks can place larger, more complex bets. They can trade in more exotic securities. They can play in areas where you would need an astute legal team to provide expert advice. As a result, big banks have fundamentally different risk profiles than small banks.
In other words, big banks are playing a different game, with different rules. The 2008 financial crisis exposed just how different, and poorly understood, these rules really are.
Don’t take my word for it. Listen to Richard Rumelt, a professor at the UCLA Anderson School of Management. Here’s how Mr. Rumelt described the game of big banks in his book, Good Strategy Bad Strategy (p. 289):
There was engineering overreach, where designers built systems whose failure models and failure consequences exceeded their ability to comprehend or analyze. The new financial instruments created in the decade leading up to the 2008 crisis had failure modes no one understood or predicted.
Simple assets have simple risk structures
When you think about the game the big banks play, they’re less redundant than a scaled-up smaller bank, or a large group of distinct smaller banks. There are some types of assets that nearly all banks have:
- Personal and commercial loans
The risks to these assets are known, and in the vast majority of cases, small. Cash isn’t going anywhere. Inflation can erode its purchasing power, but it’s still worth the same dollar amount, regardless what happens in the economy.
The only risk with treasury assets is that the government doesn’t pay back its debt. Historically, this risk is very, very small. Still, there is some political risk involved. If Congress doesn’t authorize the US government to meet its financial obligations, then securities might not be worth what we think they’re worth. In the grand scheme of things, this risk is quite small.
Personal and commercial loans are more risky than cash and treasuries. If the borrower doesn’t pay back the loan, those assets can be worth next to nothing. That’s why banks are keenly aware of credit risk, and use tools like credit scores to understand what they’re up against. They adjust principle amounts and interest rates accordingly, to ensure they protect their asset base.
For these assets, risk is a knowable, computable quantity. Yes, some institutions can still be reckless. There’s no guarantee everything turns out smoothly. But the chances of an out of control, cascading, systemic failure are very, very small. The only way to eliminate that risk, in the context of these simple asset classes, is to eliminate the banking sector. And banking is much too important to the economy to eliminate it altogether.
Big banks traffic in complex assets, with crazy, unknowable risk structures
Big banks have the same base of assets as small banks: cash, treasuries, and loans. But big banks start to collect more assets, the kinds of assets that small banks don’t have much access to. Here I’m thinking of what JPMorgan Chase calls “debt and equity instruments”, and derivatives.
These exotic instruments have different risk structures than the simpler asset classes. Take treasuries. The risk is the US government doesn’t meet its financial obligations. Or take loans. The risk is the borrowers don’t meet their financial obligations.
In these cases, the risk is confined to one entity: the government, or borrower. (The bank could also hold state or municipal bonds, which would expose it to risk at these levels of government, in addition to federal risk from treasuries.) The financial interaction between the bank and its counterparty is simple, and well understood.
For exotic instruments, we’re talking about bets the bank places on financial interactions it might not be involved with. Without getting too technical, take a credit default swap (CDS) as an example. The CDS can act as a form of insurance. With a CDS in place, if a corporate or government borrower fails to pay back its debt, the bank doesn’t lose all of its money.
That doesn’t sound like such a bad deal, right? It’s not. It makes a lot of sense. The problem comes when you start bundling CDS’s together. Rather than using a CDS as insurance, banks start using huge volumes of CDS’s to place bets on which companies and governments will default on their loans.
These exotic instruments allow for speculation in a way that the simpler asset classes don’t. That’s part of the reason that financial regulation is so difficult to get right. In a vacuum, a lot of exotic asset classes look reasonable. It’s when you bundle them together, or introduce more and more tenuous connections to “real” financial interactions, that things become nasty.
What do we do from here?
Alright. Say you agree with me that big banks are indeed uniquely dangerous. Using exotic financial instruments, they can place huge, complex bets with opaque, highly interconnected risk structures. These bets are bad for the economy. Ultimately the tax payer is on the hook, since, if the biggest banks are big enough, you need to bail them out to keep the economy working.
What next? How do we protect ourselves? The only answer is regulation. Where we can differ is the degree to which we prefer to regulate.
If we think about regulation on a continuum, we have two extremes. On one end, we have no regulation. That’s libertarianism. Banks can do whatever they’d like, however they’d like. On the other end, we have nationalization. The government owns and runs the banks. That’s Nassim Taleb’s position. (Taleb is the author of Fooled by Randomness, The Black Swan, and Antifragility.)
To put nationalization in context, think about the US military. There are a bunch of reasons the US relies on a national military, and not a collection of private forces. One risk with a private force is that it might choose to initiate conflict to protect its interests. It’s possible this conflict is not in the greater interest of the United States.
So, rather than rely on a fragmented collection of private forces, each operating in its own interest, the US nationalizes its military, and directs those forces in the interest of the population as a whole. You could make the same argument about banks.
Each person has to answer this question on their own. The US presidential campaign season that just ended featured discussion of the role of banks in the US economy. It’s an important, and timely, question to answer.
But the issue isn’t just political. There are real business implications, as we saw with the 2008 financial crisis. As we navigate through our careers, we need to have a working knowledge of the banking system. Our businesses rely on this system intimately for their survival.
We can discuss these topics further in upcoming posts.