If big banks start failing again, what will replace them? In the United States and Europe, that is a question with unsatisfactory answers in the aftermath of the financial crisis.
To put it in sports terms, there was nobody on the bench waiting for a chance to become a star. One result is that even after a crisis in which it was every country for itself, banking is becoming more internationalized than ever.
It was not always such in the United States. After the previous big financial crisis in the early 1980s, which centered on bad loans made to Latin American countries, there were major regional banks that—because of luck or wisdom—had not made the same mistakes.
Charlotte, N.C., became an international financial center. NationsBank, which began life as North Carolina National Bank, took over Bank of America. The name stayed, but the company was very different.
To some extent, the availability of a bench stemmed from a long-held suspicion of banking in the United States. Americans feared big banks long after President Andrew Jackson abolished the Bank of the United States. For most of the 20th century, banks operated in only one state. In some, Illinois most prominently, banks could have only one office.
When barriers to interstate banking fell, there were many players able to grow into major institutions. But those days seem to be gone. The banks with the ability and desire to snap up significant banks now seem to be at least as likely to be based outside the United States as inside.
If the previous crisis was largely caused by ill-advised international lending, this one was homegrown. The lending excesses centered on home mortgages, an area in which nearly every bank took part. When things blew up, there were few banks that could escape unscathed.
Still, some did better than others. JPMorgan Chase seems to have made fewer bad loans, although it has major headaches stemming from its acquisition of the assets of Washington Mutual, one of the largest irresponsible players.
Bank of America might be a shining star if it had restrained its own acquisitive instincts. Instead, it first rescued, then acquired Countrywide, which may have made more bad mortgage loans than any other lender.
Then, as the crisis grew, it picked up Merrill Lynch, an investment bank that had not figured out what you would think was something that any small-town retailer would know: If no one is buying what you are selling, there may be a problem with your product. So it bought its own products — mortgage securitizations — and kept the fees rolling. Unsurprisingly, it, or more accurately Bank of America, ended up losing money on the purchases.
All three acquisitions were encouraged by regulators, who wanted bigger institutions to buy — or at least take over with government help — smaller troubled institutions. Alas, neither the government nor the bigger banks understood the scale of the problem until it was too late. Nor did either bankers or regulators understand just how unrealistic were bank capital calculations.
There are a few well understood lessons from the debacle:
¶It is bad to have banks that are too big to fail. They may coin profits in good times, but the government is left with the bill in bad times.
¶Regulation matters. Banks in countries with good regulation fared the best. Canada has only a few major banks, but they did not get caught up in the credit bubble and are now able to buy American banks. Toronto Dominion ranked seventh in United States deposits in mid-2009, the most recent figures available, before it agreed to buy Chrysler Financial last week.
The Bank of Montreal has agreed to buy Wisconsin-based Marshall & Ilsley, which ranked 25th in 2009. Spain had a property bubble, and has many smaller banks in trouble, but strict rules kept the big Spanish banks from making the same errors that others made. They appear to be healthy.
¶Capital is crucial and so is liquidity. Regulators knew that banks were creating financial instruments whose primary purpose was to increase reported capital in dubious ways, but they did nothing about it. They completely ignored liquidity until they saw a “well-capitalized” Lehman Brothers collapse. Now regulators are phasing in tougher rules, but they fear acting too quickly because bank lending is needed now more than ever.
It can be suicidal for a country to have a financial sector that is too large, as Iceland and Ireland learned. But there is one lesson that has been overlooked: Just as big league baseball teams need a farm system to provide replacements for players who age or are injured, a banking system needs a second tier of institutions that can step in and become major league banks if necessary.
Part of the problem in Europe now is that there was no second tier available in many countries. Virtually all the banks in Ireland made the same mistakes, and there were no available replacements.
In 1994, which is not that long ago, the 10 largest banks had about a quarter of all bank deposits in the United States. Now the top 10 have more than half of the deposits. In 1994, the next 30 on the list—No. 11 through No. 40, collectively had more deposits than the top 10. Now they have much less than half.
In 1994, there was one foreign-owned institution in the top 25. That was Banco Santander of Spain, at No. 14. By 2009, there were eight. There is nothing wrong with foreign-owned banks, even if their number does come as a surprise in a country that was seen by everyone as the financial leader. But the sheer number of them is an indication of just how thin the homegrown farm system has become in the United States.
That is not an easy issue to deal with. But as the country recovers from the last crisis, regulators would do well to look to the second tier, and do all they can to assure those banks are both healthy and ready to rise if needed when the next crisis arrives.
We have learned that it is risky to have banks that are too big to fail. We need to understand that is it also risky not to have banks that are big enough to pick up the pieces when the too-big banks do fail.