Chris Papagianis on the Vicious Vortex Shaping Commercial Banking

My Economics 21 colleague Chris Papagianis identifies three ominous trends currently shaping the commercial banking sector:

(1) There were no new entrants in the banking sector in 2011. Chris notes that this is problematic because small firms depend disproportionately on small banks, but he didn’t press the point I find more disturbing — as Ashwin Parameswaran has argued, the entry of new banks might be the only way to restore the financial system to health without relying exclusively on distressed TBTF incumbents:

Although individual banks are capital constrained, the argument that an impairment in capital will induce the bank to turn away profitable lending opportunities assumes that the bank is unable to attract a fresh injection of capital. Again, this is not far from the truth: As I have explained many times on this blog, banks are motivated to minimise capital and given the “liquidity” support extended to them by the central bank during the crisis, they are incentivised to turn away offers for recapitalisation and instead slowly recapitalise by borrowing from the central bank and lending out to low-risk ventures such as T-Bonds or AAA Bonds. This of course means that they are able to avoid injecting new capital unless forced to do so by their regulator. Potential investors know of this incentive structure facing the bank and are wary of offering new equity. Moreover, injecting new capital into existing banks can be a riskier proposition than capitalising a new bank due to the opacity of bank balance sheets.

So the bank capital “limitation” that faces individual banks is real, in no small part due to the incestuous nature of their relationship with the central bank. But does this imply that the banking sector as a whole is capital constrained? The financial intermediation channel as a whole is capital constrained only if there is no entry of new firms into the banking sector despite the presence of profitable lending opportunities. Again this is empirically true but I would argue that changing this empirical reality is critical if we want to achieve a resilient financial system. The opacity of bank balance sheets means that even in the most perfectly competitive of markets, it is unlikely that old banks will find willing new investors when dramatic financial crises hit. However, investors most certainly can and should start up new unimpaired financial intermediary firms if the opportunity is profitable enough.

The onerous regulations and the time required to set up a new bank clearly discourage new entry – see for example the experience of potential new banks in the UK here. But even if we accelerate the regulatory approval process, the fundamental driver that discourages the entry of startup new banks is the Too-Big-To-Fail (TBTF) subsidy extended to the large incumbent banks that ensures that startup banks are forced to operate with significantly higher funding costs than the TBTF banks. This may be the most damaging aspect of TBTF – not only does it discriminate against existing small banks, it discourages new entry into the sector thus crippling the monetary transmission mechanism via the bank capital constraint.

This is why many of us see Dodd-Frank as an obstacle to a healthier, more resilient financial system: by dramatically increasing compliance costs, it might further entrench TBTF incumbents and further discourage the entry of new banks.

(2) In a related vein, Chris elaborates on the unfair advantage enjoyed by TBTF incumbents:

According to the FDIC, big banks’ average funding costs are one-third lower. The average funding costs for banks with more than $10 billion in assets is 0.66 percent, compared with about 1 percent for banks with less than $1 billion in assets. Why is that the case? Well, the largest banks have about 20 percent less core capital as a share of total assets compared with smaller banks (8.7 percent of total assets relative to about 10.5 percent for smaller banks). Less equity and lower funding costs result in a return on equity (the key measure for bank profitability) for big banks that is almost double that of banks with less than $100 million in assets.

When viewed through this lens, the lack of new bank entry is hardly surprising. 

(3) And finally, Chris points to the federal government’s growing influence over the allocation of consumer credit.

The consumer credit market comprises about $13 trillion in outstanding loans or debt. The mortgage market, or home loans, make up the overwhelming majority of this total (a little over $10 trillion). The other major categories are student loans, credit cards and auto loans (about $2.5 trillion). Today, the government has outstanding guarantees on close to 60 percent of all mortgage-related debt, or almost $6 trillion in aggregate. Moreover, practically every new home loan made today is backed by the government, so this percentage and aggregate dollar amount is only climbing. And for certain mortgages, the government is happy to offer special benefits to the banks or lenders that are responsible for the most loan volume (see page 8 of this report).

The effect is that the government is determining the underwriting standards — who gets qualified for a loan and who doesn’t — and is bearing 100 percent of the credit risk on loan defaults, while private banks and lenders serve effectively as middlemen processing paperwork and helping to match consumers with the right government-guaranteed loan product.

The transformation of private banks and lenders into middlemen raises the question of why they should be allowed to take a cut off of the top. Unless the government pulls back from the consumer credit market, there is a real danger that growing state control, which is to say growing politicization, of economic decision-making will lead to more rent extraction by politically-connected insiders, more barriers to entry, and less growth. As Chris suggests, we’re shifting from a healthy mix of entrepreneurial and big-firm capitalism to a toxic mix of state-guided and oligarchic capitalism:

What’s particularly disturbing about these three trends is how the underlying dynamics are interrelated and actually reinforcing one another. Small banks are being pushed to the side by big banks. The banks that are “too big to fail” are only getting larger and adding to their market share of consumer loans. But then a closer examination of who exactly is responsible for the losses when a consumer defaults on a loan (increasingly, it’s the taxpayer) reveals the true depths of the government’s influence, if not control, over consumer credit.

Snapping this vicious vortex is perhaps the greatest challenge that policymakers and the U.S. economy face in the coming years. A future where the provision of consumer credit is increasingly dictated by big banks and government bureaucrats is not consistent with the image that Americans like to project across the world, namely that the U.S. is a beacon or defender of private markets and capitalism.

Do any of the major presidential candidates understand this evolving landscape? 

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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