Not Too Big Enough
How the "too-big-to-fail" banks got that way, and why
the current banking reform won't solve the problem.
By Rob Larson
Dollars and Sense
The government bailout of America's biggest banks set
off a tornado of public anger and confusion. With a
price tag in the trillions of dollars, rescuing the
biggest American banks has left the public resentful
over the bailout of banks considered "too big to fail."
But two years later, the Senate has rejected a proposal
to break up today's "megabanks" into smaller
institutions, claiming that tougher reserve requirements
and higher insurance premiums will prevent future large-
scale bank failures.
Dealing with the collapse of these "systemically
important banks" is a difficult policy issue, but the
less-discussed issue is how the banking industry got to
this point. If the collapse of just one of our $100
billion megabanks, Lehman Brothers, was enough to touch
off an intense contraction in the supply of essential
credit, we need to know how some banks became "too big
to fail" in the first place. The answer lies in certain
incentives for bank growth, which after the loosening of
crucial industry regulations drove the enormous waves of
bank mergers in the last thirty years. Economies of
Scale in Banking and Finance
Economies of scale are savings that companies benefit
from as they grow larger and produce more output. While
common in many industries, in banking and finance these
economies drove bank growth after industry deregulation
in the 1980s and 1990s. Some of the major scale
economies in banking are:
* Spreading investment over more output. With the
growth in importance of large-scale computing power
and sophisticated systems management, the costs of
setting up a modern banking system are very large.
However, as a firm grows it can "spread out" the
cost of that initial investment over more product,
so that its cost per unit decreases as more output
* Consolidation of functions. The modern workforce
is no stranger to the mass firings of "redundant"
staff after mergers and acquisitions. If one firm's
payroll staff and computer systems can handle twice
the employees with little additional expense, an
acquired bank may see its payroll department harvest
pink slips while the firm's profitability improves.
When Citicorp merged with the insurance giant
Travelers Group in 1998, the resulting corporation
laid off over 10,000 workers-representing 6% of the
combined company's total workforce and over $500
million in reduced costs for Citigroup. This
practice can be especially lucrative in a country
like the United States, with a fairly unregulated
labor market where firms are quite free to fire.
Despite the economic peril inflicted on workers and
their families, this consolidation is key to
increasing company efficiency post-merger. Beyond
back-office functions, core profit operations may
also benefit from consolidation. When Bank of
America combined its managed mutual funds into a
single fund, it experienced lower total costs,
thanks to trimming overhead from audit and
prospectus mailing expenses. Consolidating office
departments in this fashion can yield savings of 40%
of the cost base of the acquired bank.
* Funding mix. The "funding mix" used by banks
refers to where banks get the capital they then
package into loans. Smaller institutions, having
only limited deposits from savers, must "purchase
funds" by borrowing from other institutions. This
increases the funding cost of loans for banks, but
larger banks will naturally have access to larger
pools of deposits from which to arrange loans. This
funding cost advantage for larger banks relative to
smaller ones represents another economy of scale.
* Advertising. The nature of advertising requires a
certain scale of operation to be viable. Advertising
can reach large numbers of potential customers, but
if a firm is small or local, many of those customers
will be too far afield to act on the marketing.
Large firm size, and especially geographic reach,
can make the returns on ad time worth the
Geographical Growth and Economies of Scale
Before the 1980s, American commercial banking was a
small-scale affair. State-chartered banks were
prohibited by state laws from running branches outside
their home state, or sometimes even outside their home
county. Nationally chartered banks were likewise
limited, and federal law allowed interstate acquisitions
only if a state legislature specifically decided to
permit out-of-state banks to purchase local branches. No
states allowed such acquisition until 1975, when Maine
and other states began passing legislation allowing at
least some interstate banking. The trend was capped in
1994 by the Riegle-Neal Act, which removed the remaining
restrictions on interstate branching and allowed direct
cross-state banking mergers.
This geographic deregulation allowed commercial banks to
make extensive acquisitions, in-state and out. When
Wells Fargo acquired another large California bank,
Crocker National, in 1986 it was the largest bank merger
in U.S. history. Since "the regulatory light was green,"
a single banking company could now operate across the
uniquely large U.S. market, opening up enormous new
opportunities for economies of scale in the banking
Economies of scale are savings that companies enjoy when
they grow and produce more output. The situation is
similar to a cook preparing a batch of cookies for a
Christmas party and then preparing a batch for New
Year's while all the ingredients and materials are
already out. Producing more output (cookies) in one
afternoon is more efficient than taking everything out
again later to make the New Year's batch separately. In
other words, there's less effort per cookie if you make
them all at once. In enterprise, this corresponds to
spreading the large costs of startup investment over
more and more output, and is often thought of as lower
per-unit costs as the level of production increases.
Economies of scale, when present in an industry, create
a strong incentive for firms to grow larger, since
profitability will improve. But they also give larger,
established firms a valuable cost advantage over new
competitors, which can put the brakes on competition.
Once unleashed by the policy changes, these economies of
scale played a major role in the industry's seemingly
endless merger activity. "In order to compete, you need
scale," said a VP for Chemical Bank when buying a
smaller bank in 1994. Of course, in 1996 Chemical would
itself merge with Chase Manhattan Bank.
Spreading big investment costs over more output is the
main source of generic economies of scale, and in
banking, the large initial investments are in
sophisticated computer systems. The cost of investing in
new computer hardware and systems is now recognized as a
major investment obstacle for new banks, but once they
are installed by banks large enough to afford them, they
are highly profitable. The Financial Times describes how
"the development of bulk computer processing and of
electronic data transmission...has allowed banks to move
their back office operations away from individual
branches to large remote centers. This has helped to
bring real economies of scale to banking, an industry
which traditionally has seen dis-economies set in at a
very modest scale."
Economies of scale are common in manufacturing, and in
the wake of deregulation the banking industry was also
able to exploit a number of them. Besides spreading out
the cost of computer systems, economies of scale may be
present in office consolidation, in the funding mix used
by banks, and in advertising. (See sidebar.) Industry-
BusinessWeek's analysis is that the banking industry
"has produced large competitors that can take advantage
of economies of scale...as regulatory barriers to
interstate banking fell," although not until the banks
could "digest their purchases." The 1990s saw hundreds
of bank purchases annually and hundreds of billions in
But an additional major turn for the industry came with
the Gramm-Leach-Bliley Act of 1999 (GLB), which further
loosened restrictions on bank growth, this time not
geographically but industry-to-industry. After earlier
moves in this direction by the Federal Reserve, GLB
allowed for the free combination of commercial banking,
insurance, and the riskier field of investment banking.
These had been separated by law for decades, on the
grounds that the availability of commercial credit was
too important to the overall economy to be tied to the
volatile world of investment banking.
GLB allowed firms to grow further, through banks merging
with insurers or investment banks. The world of
commercial credit was widened, and financial mergers
this time exploited economies of scope-where production
of multiple products jointly is cheaper than producing
them individually. As commercial banks, investment
banks, and insurers have expanded into each others'
fields in the wake of GLB, their different lines of
business can benefit from single expenses-for example,
banks perform research on loan recipients that can also
be used to underwrite bond issues. Scope economies such
as these allow the larger banks to both run a greater
profit on a per-service basis and attract more business.
Thanks to the convenience of "one stop shopping,"
Citigroup now does more business with big corporations,
like IT giant Unisys, than its component firms did pre-
Exploiting economies of scope to diversify product lines
in this fashion can also help a firm by reducing its
dependence on any one line of business. Bank of America
weathered the stock market downturn of 2001 in part
because its corporate-debt-underwriting business was
booming. Smaller, more specialized banks can become
"one-trick ponies" as the Wall Street Journal put it-
outdone by larger competitors with low-cost
diversification thanks to scope economies.
These economies of scope are parallel to the scale
economies, since both required deregulatory policy
changes to be unleashed. Traditionally, banking wasn't
seen as an industry with the strong economies of scale
seen in, say, manufacturing. But the deregulation and
computerization of the industry have allowed these firms
to realize returns to greater scale and wider scope, and
this has been a main driver of the endless acquisitions
in the industry in recent decades.
The enormous proportions that the banking institutions
have taken on following deregulation have meant serious
consequences for market performance. A number of banks
have reached sufficient size to exercise market power-
the ability of firms to influence prices and to engage
in anticompetitive behavior. The market power of our
enormous banks allows them to take positions as price
leaders in local markets, where large firms use their
dominance to elevate prices (i.e., increase fees and
rates on loans, and decrease interest rates on
deposits). Large firms can do this because smaller firms
may perceive that lowering their prices to take market
share could be met by very drastic reductions in prices
from the larger firm in retaliation. Large firms, having
deeper pockets, may be able to withstand longer periods
of operating at a loss than the smaller firms.
Small banks are likely to perceive that the colossal
size and resources of the megabanks make them
unprofitable to cross-better to follow along and charge
roughly what the dominant, price-leading firm does.
Empirical research by Federal Reserve Board senior
economist Steven Pilloff supported this analysis,
finding that the arrival of very large banks in local
markets tended to increase bank profitability for
reasons of price leadership, due to the larger banks'
economies of scale and scope, financial muscle, and
Examples of the use of banking industry market power are
easy to find. Several bills now circulating Congress
deal with the fees retail businesses pay to the banks
and the credit-card companies. When consumers make
purchases with credit cards, two cents of each dollar
goes not to the retailer but to the credit card
companies that run the payment network and the banks
which supply the credit for cards branded Visa and
MasterCard. These "interchange fees" bring in over $35
billion in profit in the United States alone, and they
reflect the strong market power of the banks and credit
card companies over the various big and small retailers.
The 2% charge comes to about $31,000 for a typical
convenience store, just below the average per-store
yearly profit of $36,000; this has driven a coalition of
retailers to press for congressional action.
Visa has about 50% of the debit-credit card market, and
MasterCard has 25%, which grants them profound market
power and strong bargaining positions. Federal Reserve
Bank of Kansas City economists found the United States
"maintains the highest interchange fees in the world,
yet its costs should be among the lowest, given
economies of scale and declining cost trends." The Wall
Street Journal's description was that "these fees...have
also been paradoxically tending upward in recent years
when the industry's costs due to technology and
economies of scale have been falling." Of course,
there's only a paradox if market power is omitted from
the picture. The dominant size and scale economies of
the banks and the credit-card oligopoly allow for high
prices to be sustained-bank muscle in action against a
less powerful sector of the economy. The political
action favored by the retailers includes proposals for
committees to enact price ceilings or (interestingly)
collective bargaining by the retailers. As is often the
case, the political process is the reflection of the
different levels and positions of power of various
corporate institutions, and the maneuvering of their
Market power brings with it a number of other
advantages. A powerful company is likely to have a
widespread presence, make frequent use of advertising,
and be able to raise its profile by contributing to
community organizations like sports leagues. This allows
the larger banks to benefit from stronger brand
identity-their scale and resources make customers more
likely to trust their services. This grants a further
advantage in the form of customer tolerance of higher
prices due to brand loyalty. Political Clout
Crucially, large firms with market power are free to
participate meaningfully in politics-using their deep
pockets to invest in electoral campaigns and
congressional lobbying. The financial sector is among
the highest-contributing industries in the United
States, with total 2008 campaign contributions
approaching half a billion dollars, according to the
Center For Public Integrity. So it's unsurprising that
they receive so many favors from the state, since they
fund the careers of the decision-making state personnel.
This underlying reality is why influential Senator Dick
Durbin said of Congress, "The banks own the place."
Finally, banks may grow so large by exploiting scale
economies and market power that they become
"systemically important" to the nation's financial
system. In other words, the scale and interconnectedness
of the largest banks are considered to have reached a
point where an abrupt failure of one or more of them may
have "systemic" effects-meaning the broader economic
system will be seriously impaired. These are the banks
called "too big to fail," which were bailed out by act
of Congress in the fall of 2008. Once a firm becomes so
enormous that the state must prevent its collapse for
the good of the economy, it has the ultimate advantage
of being free to take far greater risks. Riskier
investments come with higher returns and profits, but
the accompanying greater risk of collapse will be less
intimidating to huge banks that have an implied
government insurance policy.
Some analysts have expressed doubt that such firms truly
are too large to let fail, and that the banks have
pulled a fast one. It might be pointed out in this
connection that in the past the banks themselves have
put their money where their mouths are-they have paid
out of pocket to rescue financial institutions they saw
as too large and connected to fail. An especially
impressive episode took place in 1998, when several of
Wall Street's biggest banks and financiers agreed to
billions in emergency loans to rescue Long Term Capital
Management (LTCM), a high-profile hedge fund that had
borrowed enormous sums of capital to make billion-dollar
gambles on financial markets.
America's biggest banks aren't in the habit of forking
over $3.5 billion of good earnings, but they had loaned
heavily to LTCM and feared losing their money if the
fund went under. The Federal Reserve brought the bankers
together, and in the end, they paid up to bail out their
colleagues; the Wall Street Journal reported that it was
the Fed's "clout, together with the self-interest of
several big firms that already had leant billions of
dollars to Long-Term Capital, that helped fashion the
rescue." Interestingly, the banks insisted on real
equity in the firm they were pulling out of the fire,
and they gained a 90% stake in the hedge fund. Comparing
this to the less-valuable "preferred stock" the
government settled for in its 2008 bailout package of
the large banks is instructive. The banks also got a
share of control in the firm they rescued, again in
stark contrast to the public bailout of some of the same
banks. Even Bigger?
In fact, the financial crisis and bailout led only to
further concentration of the industry. The crisis gave
stronger firms an opportunity to pick up sicker ones in
another "wave of consolidation," as BusinessWeek put it.
And a large part of the government intervention itself
involved arranging hasty purchases of failing giants by
other giants, orchestrated by the Federal Reserve. For
example, the Fed helped organize the purchase of Bear
Stearns by Chase in March 2008 and the purchase of
Wachovia by Wells Fargo in December 2008. Even the
bailout's "capital infusions" were used for further
mergers and acquisitions by several recipients. The
Treasury Department was "using the bailout bill to turn
the banking system into the oligopoly of giant national
institutions," as the New York Times reported.
The finance reform bill, still emerging as Congress'
response to the financial crisis, has had most of its
tougher elements rejected. Notably, a proposal to pay
for future bailouts by a special tax on the megabanks
was dropped from the bill, and no provisions remain that
would actively break up the systemically important
institutions. The main thrust is to oblige banks to hold
somewhat more reserve capital, and other small reforms,
many influenced by the Basel Committee, which is
negotiating international banking accords. The goal is
to prevent another megabank bailout with the public's
money, but as Tony Jackson wrote in the Financial Times,
"Governments may swear blind they will not stand behind
bank creditors. But if the market correctly surmises
official nerve will crack in a crisis, these
protestations are worthless."
The monumental growth of the largest banks owes a lot to
the industry's economies of scale and scope that
developed once regulations were relaxed so firms could
exploit them. While certainly not unique to finance,
these dynamics have brought the banks to such enormous
size that their bad bets can put the entire economy in
peril. Banking therefore offers an especially powerful
case for the importance of these economies and the role
of market power, since it's left the megabanks holding
all the cards.
In fact, many arguments between defenders of the market
economy and its critics center on the issue of
competition vs. power-market boosters reliably insist
that markets mean efficient competition, where giants
have no inherent advantage over small, scrappy firms.
However, the record in banking clearly shows that banks
have enjoyed a variety of real benefits from growth. The
existence of companies of great size and power is a
quite natural development in many industries, due to the
appeal of returns to scale and power. This is why firms
end up with enough power to influence state policy, or
such absurd size that they can blackmail us for life
support-and leave us crying all the way to the bank.
How Did They Get So Big?
A Too-Big-to-Fail Timeline
By Jill Mazzetta
1975: Maine becomes the first state to open its borders
to out-of-state banks. Other states quickly follow suit.
1977: Lehman Brothers merges with Kuhn, Loeb & Co.;
becomes fourth-largest investment bank in the United
1984: Lehman Brothers acquired by Shearson/American
Express, a brokerage company, for $360 million.
1986: Wells Fargo acquires Crocker National Bank for
about $1.1 billion; becomes the tenth largest commercial
bank in the United States; sets record for largest bank
acquisition in history.**
1992: Bank of America acquires Security Pacific
Corporation; takes title of largest bank acquisition in
1994: Riegle-Neal Act passed. Allows national banks to
set up branches anywhere in the United States,
regardless of whether they own a subsidiary in any state
they receive deposits from.
Bank of America acquires Continental Illinois National
Bank and Trust Co.; becomes the largest U.S. bank in
terms of deposits.
1995: Wells Fargo acquires First Interstate Bancorp for
$11.3 billion in hostile takeover; becomes ninth largest
1996: Chemical Bank acquires Chase Manhattan Corp. and
takes its name.
1997: NationsBank Corp. acquires Bank of America for
$64.8 billion; sets new record for the largest bank
acquisition in history.
1998: First Union acquires CoreStates Financial Corp.
for $17 billion.
Long-Term Capital Management (LTCM) runs out of funds.
Federal Reserve Bank of New York organizes a $3.6
billion bailout by several major creditors, including
Goldman Sachs, JP Morgan, and Lehman Brothers.
Participating banks get a 90% share in LTCM.
Citicorp merges with Travelers Group to form Citigroup
for $70 billion; becomes world's largest financial
Wells Fargo merges with Norwest for $31.7 billion.
1999: Gramm-Leach-Bliley Act passed. Repeals part of
Glass-Steagall Act of 1933, allowing commercial banks,
insurance companies, investment banks, and securities
firms to merge with each other.***
2000: Chase Manhattan merges with J.P. Morgan & Co. to
form JP Morgan Chase.
2001: WaMu acquires PNC Mortgage Co. and Fleet Mortgage
Lehman Brothers acquires Cowen & Co.
2003: Lehman Brothers acquires Crossroads Group and
Neuberger Berman. Faces SEC litigation; pays $80 billion
settlement; forced to restructure.
Wachovia acquires Metropolitan West Securities; adds
over $50 billion in securities to its portfolio.
2004: Bank of America acquires FleetBoston Financial for
JP Morgan Chase merges with BankOne Corp.
Wachovia acquires SouthTrust Corp. for $14.3 billion;
becomes the largest bank in southeastern United States.
2005: Bank of America acquires MBNA (Maryland Bank,
National Association) for $35 billion.
2006: Wachovia acquires Golden West Financial for about
2007: April: Citigroup suffers from subprime mortgage
crisis; eliminates 17,000 jobs.
August: Lehman Brothers closes BNC Mortgage, its
subprime lending firm; leads to 1,200 job cuts.
Bank of America acquires Countrywide Financial for $4.1
billion; becomes the country's leading mortgage
servicer, cornering about 25% of the market. Countrywide
becomes Bank of America Home Loans.
September: Bank of America acquires LaSalle Bank for $21
December: WaMu reorganizes loan division, closing
offices and laying off 2,600 staff.
2008: March: JP Morgan Chase acquires Bear Stearns for
April: WaMu closes offices and lays off 3,000 due to
subprime mortgage crisis; receives $7 billion infusion
from outside investors.
September: Massive bank run on WaMu; customers withdraw
$16.7 billion over 10 days.
Lehman Brothers files for Chapter 11; is the largest
bankruptcy in U.S. history.
Bank of America acquires Merrill Lynch for about $50
billion; becomes the world's largest financial services
WaMu seized by the Office of Thrift Supervision, handed
over to FDIC; FDIC sells WaMu's assets, debts, and
deposits to JP Morgan Chase for $1.9 billion.
Wachovia declared "systematically important," i.e. too
big to fail, by the FDIC; FDIC plans to auction off its
October: Emergency Economic Stabilization Act ("the
bailout") passes. Allows U.S. Treasury to spend $700
billion purchasing troubled assets (e.g. subprime
mortgages) and injecting capital directly into banks.
Goldman Sachs receives $10 billion in TARP funds.
November: U.S. government agrees to back $306 billion in
Citigroup's loans and invest another $20 billion
directly into the company.
December: Wachovia acquired by Wells Fargo for $15.1
billion to avoid failure.
2009: January: Bank of America reports massive losses
from Merrill Lynch; receives $20 billion in emergency
TARP bailout funds to stay solvent, in addition to an
initial TARP investment of $25 billion from fall 2008.
March: New York Times article claims Bank of America
received an additional $5.2 billion in government funds,
channeled through AIG.
June: Goldman Sachs repays TARP investment with
August: Bank of America agrees to pay $33 million fine
to SEC for not disclosing bonus payments totaling $5.8
million to top Merrill Lynch employees.
December: Bank of America announces it will repay the
$45 billion it received from TARP and exit the program.
*Investment bank size measured by revenue or fee income
and by market share as opposed to commercial banks,
which are measured by deposits and market share. **Bank
acquisitions are measured and ranked based on price paid
by the acquiring company. ***Major turning point in
deregulation: to reflect the fact that banks can now
offer a variety of financial services, bank holding
companies begin ranking themselves by asset size and
market capitalization, not deposit size. These multi-
service institutions are no longer technically
classified as banks, but as "financial service
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