Friday, November 13, 2009

Yes, We Need Big Banks

As I've said before, I think the idea that "too big to fail, too big to exist" idea is just silly—it betrays a fundamental lack of knowledge about the way modern financial markets work. The pundits who push this idea love to argue that banks don't need to have huge balance sheets, and that there's no benefit to having banks with balance sheets of over, say, $400 billion or so. This argument, too, is almost adorably naïve. (The whole thing can also be refuted in four words: Long-Term Capital Management.) It's been odd to watch the debate on bank size though, because the people defending big banks in the media/blogosphere (e.g., Charles Calomiris) have somehow managed to avoid mentioning the one reason banks do actually need very large balance sheets: market-making. The major banks are all market-makers (or "dealers") in fixed-income products, currencies, OTC derivatives, commodities, and equities. In general, dealers in a given security stand ready and willing to buy or sell the security for their own account, at publicly quoted bid and offer prices. Market-making, especially in fixed-income products, is very capital-intensive. You need a very large and diverse balance sheet to be a market-maker in fixed-income products—government securities, investment grade corporate bonds, high-yield bonds, mortgage-backed securities, bank and secured loans, consumer ABS, distressed debt, emerging market bonds, etc. Dealers hold inventories of all these securities because they need to remain "ready and willing" to sell, and because when they buy a security from a client, they need to hold it in inventory until a buyer for the security appears. Dealers are exposed to price movements for the period they hold the security in inventory, and because inventories can grow large in a short amount of time, sharp price movements can result in substantial losses for dealers. So dealers hedge. Constantly. The cheapest way for dealers to hedge is internally—that is, when the security or derivative it buys can offset an exposure elsewhere on its balance sheet. The next cheapest way for a dealer to hedge is generally with liquid, vanilla derivatives (e.g., interest rate swaps). So imagine an MBS dealer that buys a large position from a client, and has to hedge the interest rate risk. If the dealer also happens to be a market-maker in interest rate derivatives, then either: (a) the interest rate risk on the MBS will offset one of the rates desk's exposures; or (b) the rates desk will go into the market and hedge the interest rate risk with a plain-vanilla derivative, which it can do very cheaply because as a market-maker, it does these kinds of trades all the time. So being a market-maker in interest rate derivatives is critical to effectively managing the risks of holding MBS in inventory—and if you can't effectively manage the risks in a large inventory of MBS, then you simply can't offer cost-effective market making in MBS. What's more, dealers also need to set aside capital for their market-making in the OTC derivatives that they use to hedge their fixed-income market-making. Now think about all the different kinds of risks involved in holding inventories of the fixed-income products I listed above. We're talking about foreign exchange risk, interest rate risk, credit risk, basis risk, etc. Hedging all of that, dynamically, is a necessary component of market-making. This is why, for example, Goldman bought CDS protection from AIG on the super-senior tranches of CDOs it underwrote. The point of creating CDOs was to generate a mezzanine tranche, which investors, who had a seemingly insatiable thirst for yield, would gobble up. Goldman (and other dealers) couldn't place the super-senior tranches, so they held the super-seniors on their books and hedged all that risk by buying CDS protection from AIG (and the monolines). There's nothing nefarious about this—hedging is just what dealers do. Alas, this concept is apparently too difficult for the Matt Taibbis of the world to get their minds around. As you can imagine, all the risks that a major dealer bank has to manage on a daily basis—the constantly changing level of their exposures, how those exposures all interact, etc.—gets extraordinarily, mind-bogglingly complicated. The major banks all made huge investments to develop the technological capacity to manage those risks, and it's pretty clear they didn't invest enough in their risk management systems. There are only two banks that I've seen that clearly did make the necessary investments in risk management (Goldman and JPMorgan, not surprisingly). So there are undoubtedly economies of scale there. Another place there are economies of scale is order flow. The larger a dealer's order flow, the more trades it can match internally. This reduces volatility, allows a dealer to hold smaller inventories of securities, and reduces its exposure to sharp price movements. A lot of the financial industry's "merger mania" over the past 15 years was driven by the race to capture order flow. So why do we need these massive market-makers in the first place? They ensure liquidity in the capital markets. And why is that important? For one thing, it lowers borrowing costs—investors are much more willing to buy a bond issue if they know they can quickly and easily sell the position later if they want to. Investors demand higher yields for illiquid bonds. The benefits of having massive market-makers were passed on to all the businesses that were able to borrow in the capital markets at a much lower cost, and to all the investors who enjoyed much higher returns due to the reduced transaction costs. Having liquid capital markets also allows the use of mark-to-market accounting, which is an important check on corporate management. During the whole nationalization debate, everyone was screaming bloody murder about the fact that the banks didn't have to mark their toxic assets to market. Well, if we "break up" the major banks, as some simpletons pundits are urging, then you can forget about being able to mark-to-market lots of fixed-income products and OTC derivatives. Of course, there's no chance that we're going to break up the major banks. Tim Geithner isn't an idiot, and he's not an attention-craving pundit. Unfortunately, most pundits are apparently unable to distinguish between recognizing the benefits of big banks and being "captured by Wall Street" (which is a red herring). So if you've somehow made to the end of this post, I hope you'll be able to see through the claims that Geithner's unwillingness to break up the major banks is proof that he's been "captured by Wall Street."

36 comments:

Anonymous said...

of course, tim geithner isn't going to explain this to the public, and so he will always look wrong in their eyes.

Axel Molotov said...

Interesting post. So here's my inquiry. Don't you think that market-maker is just another name for a monopoly? I guess I am challenging the underlying assumption that it's a good thing for an institution to do so much under one roof, and subsequently, to assume the vast amount of risk you reference.
By limiting the number of areas in which an entity could be a market-maker, we would thereby regulate the amount of risk one entity would assume. This tactic would also then help moderate the tbtf phenomenon and silence those pundits of which you speak.

Anonymous said...

i'm sorry, but any institution that overtly/covertly relies on exogenous support is not really managing all the risks associated with what you describe as "market-making" on account of its size.

and since it is clear that the bigger an institution gets, the stronger the overt/covert guarantee of exogenous support, i would argue that the ability to take on risk is fundamentally dependent on the perception of infallibility. note that logically, infallibility is not the same as enormity.

indeed, if the government guaranteed all liabilities of a smallish institution, then that firm can engage in the market-making activities you describe.

in short, in the post-crisis world, it is clear that size (in and of itself) does not inspire confidence in counterparties. size alone is not a sufficient condition for the ability to make markets. no bank is big enough to manage ALL of the risks associated with market-making activities.

of course, the logic of your post is just so circular -- if big banks were able to sufficiently manage the risks from their activities, why did the system need critical exogenous support at a critical moment? or, are you implying that the banks we have are not big enough. if so, what size bank is big enough?

and, is the benefit of having big banks having to dole out a ginormous amount of support guaranteed, for better or worse, by the entirety of the populace?

i think the idea of "economies of scale" when it comes to banking (of the money center, market making kind) is the red herring. not the other way around.

yequalsx said...

You wrote:

As I've said before, I think the idea that "too big to fail, too big to exist" idea is just silly—it betrays a fundamental lack of knowledge about the way modern financial markets work.

Isn't the point that 'modern financial markets' don't work? Or, rather, leave us underlings on the hook when they don't work? Goldman has $15 billion in bonus pay this year so I guess modern finance is working just well.

Anonymous said...

Wouldn't breaking up the market into smaller chunks aka pre-Steagall-Glass repeal make sense then? They would still be "market makers", but only in one part of three separate (or more) markets rather than all under one roof.

Cetamua said...

We need big banks if we need OTC derivatives and all these fancy and "innovative" products.

We've lived centuries without them, including the last one. So, society could easily take a royal pass on these again without regressing to the Middle Ages. Not so much the CEOs of these big banks but no one ever guaranteed their existence.

Anonymous said...

yah, this big ball of debt has worked out real good! load up on debt and take home your fat check. i'll take one kid that makes a wind mill in his famine-homeland over every last *$&#sucker that made the curve at wharton.

Anonymous said...

Wonderful article, it reminds me of the old saying.\; The biggest whores do not stand on street corners.

james c said...

The argument presupposes that less swaps trading would take place if one big bank were broken up into two smaller ones.
Why?

David Pearson said...

Wow, what a bunch of B.S.

Markets were made in the 1990's in the types of securities you refer to, before the explosive growth of bank balance sheets. Please provide some evidence that MBS, Treasury, corporate, high yield, rate and FX swap, or any number of other spreads have come in (narrowed) as a result of bank balance sheet growth. CDS and CDO spreads? Maybe they came in, but was that necessarily a "good thing"?

Second, the concept that banks did not invest enough in risk management tools is ludicrous. Legions of math PHD's were hired by the street to build risk models; arguably more money than ever before was invested. Guess what? The models all failed to predict the crisis. In fact, they helped CAUSE the crisis by severely underestimating "tail risk". Your solution: hire MORE PHD's; build MORE models? Laughable. What "risk model" told Goldman to short subprime in 2008? I challenge you to find out that it was the product of scale-enabled investment! (And John Paulson must have made the same investment, even though he only managed a few billion.) Also, Citi is LARGER than Goldman, so I'm confused, is it scale or management skill that drives good risk management?

Also, larger institutions most certainly do not "ensure liquidity" in the market place. We just had a severe liquidity crisis amongst TBTF firms. Were you out of the country then? The whole point of TBTF antagonists is that we should not concentrate liquidity in such a way ever again.

Banks did not get into trouble because they made markets; they got into trouble because they blew up their balance sheets with long term, illiquid assets funded with ultra-short, ultra-cheap money. Ever heard of Lehman's CRE portfolio? Bear's and Merrill's subprime CDO's? Goldman's excessive concentration of CDS counterparty risk (which almost sunk the firm -- ah, those more-expensive Goldman models probably predicted we would all bail them out, right?)?

Ludicrous. Just ludicrous.

Anonymous said...

David Pearson, how does breaking up the systemically important financial institutions change systemic risk and the devastating nature of a systemic crisis?

Saying what existed faired poorly in a systemic crisis seems pointless to me. Of course they faired poorly. It was a systemic crisis.

How would broken-up banks fair economically in the 95 out of 100 years when there is no systemic crisis?

David Pearson said...

In fairness, let me attempt to summarize your argument in dry, economic terms:

"I have determined that the economy-wide benefit from letting large rent-seeking firms capture the lions share of a marginal improvement in financial transaction costs exceeds...

...the cost of having taxpayers backstop these firms when, due to excessive risk concentration, they eventually come close to failure and, despite a massive bailout, still manage to precipitate a crisis that drives the unemployment rate into double digits."

Sound about right?

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anne said...

I agree with you that we will not see the government break up the big banks.

However, I remain unclear on the need for banks so large that their failure requires a massive government intervention to prop up the economy/financial sector/bonus structure of failed institutions like AIG.

If banks remain "too-big-to-fail" - what happens when their business practices lead to failure? Do we let them go belly up? Do we gear up another TARP? If they are so big that their failure cannot happen without catastrophic consequences for the economy, what do you think should happen when they do in fact fail?

"Goldman (and other dealers) couldn't place the super-senior tranches, so they held the super-seniors on their books and hedged all that risk by buying CDS protection from AIG (and the monolines). There's nothing nefarious about this—hedging is just what dealers do."

What I'd like to know - who, outside of GS and other dealers, benefits from this kind of hedging? Nothing nefarious, yes, but outside of the rare birds on Wall Street, who gains?

Millions of jobs have been lost since the financial sector choked on debt of its own making. So what's working for Goldman didn't work at all in the economy at large. Or is that economy irrelevant?

Anonymous said...

Why is it not possible for the smaller banks to hold a bit more capital and shoulder the risks themselves? Or simply charge a little more interest? Or recapitalize some monolines/LMI providers and get them to charge a realistic rate?

I'm a little surprised your using AIG as an example. It's clear markets substantially mispriced the counterparty risk in AIG.

What you need to show is that the economic costs of larger credit spreads or more bank capital will be materially higher than the costs of periodic bailouts and credit-induced recessions.

I for one would prefer to pay an extra 50-100 bps on my mortgage or get fewer pre-approved credit cards in the mail so I won't have to pay massively more in tax down the track to bail out banks and for the welfare expense of 10% unemployment.

Anonymous said...

anne, except you dont ask how many of those "millions of jobs lost" were jobs that could have existed with the asset bubble that happened...

Danny

anne said...

To Danny, if you're implying that the asset bubble created all sorts of new jobs that would vaporize when the bills came due, then please explain the value of the big banks and all that marvelous financial innovation...

If only those on Wall Street benefit from the bigness of banks, then I'm not seeing the value of such bigness.

Anonymous said...

MBS structures, CDS's, and even ordinary puts/calls in the presence of the well-known and -documented fat-tail risks are all evaluated using models implying, to use the technical parlance, that markets are incomplete: By definition the product cannot be hedged within the model. Even though the model can construct a "price," that price is not unique since other models with equal consistency to observable market prices can produce other prices [1].

Further, since the methodology uses only the most pedantically tenuous connection to any presumed historical/projected frequency of events [2], the quality of the valuations cannot, by virtue of the very finance theory justifying their existence in the first place, be judged by reference to history nor even to any given self-consistent probabilistic view of the future. Hedging claims by Wall Street are vacuous posturing to a gullible public. September/October 2008 proved it.

Notes:
[1] The probability measure used for valuation that is/has been presumptively calibrated to market prices on other securities--the equivalent martingale measure (EMM)--is known to be non-unique.
[2] The tenuous connection: the EMM assigns zero probability to events similarly assigned zero likelihood by a given probability measure for history/projections; and vice versa.

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nick gogerty said...

I will trade efficiency in the short term for longer term stability. Smaller more transparent participants are more desirable. Saftey vs. speed. The airbags of higher capital requirements, smaller firms etc. might cost more in the short run, but are a better investment in systemic stability for the long run. For those interested in ongoing discussions of systemic stability you may want to check out the black swan group in linkedin.com

Nick said...

The points made in the article are good ones, so far the objections in the comments are in my opinion intellectually weak / misinformed / off topic...

Saying that in the 19th century we lived fine without big banks is more or less like saying that we lived fine without computers. Somehow, nobody seems to think that's a smart idea (not even Tabibi, or whatever his name is).

We live in a totally different world with global companies that operate in multiple currencies and are exposed to more complex risks. Investors globally are looking to diversify and hedge against multiple risks.
Based on that alone, the need for large scale banks seems to me obvious. That does not mean that the current system has failed in various key aspects with a high severity. Over-complexity which is under-regulated is a real issue. It does mean that we should not make arbitrary conclusions based on over-simplifications / (even worse) populism.

Anonymous said...

The average cost of credit as measured by the spread over Treasuries has increased since the advent of securitization in the 1970s. With today's near-ZIRP the spread is historically wide. Big banks have demonstrably increased, not decreased the cost of credit. Credit has been cheap because of the unholy alliance of the Fed, Japan, and other Asian nations kept it cheap.

As far as market liquidity, it should be quite plain that hedging between 10 separate entities has the same net buying capacity as a single huge entity 10x as large doing self-dealing hedging. Those 10 entities are also less able to commit accounting fraud by inflating asset values on their balance sheets.

You don't need big market makers to make markets with liquidity, you just need lots of market participants. Having big market makers just creates opportunities for fraud and illegal trading.

Anonymous said...

"publicly quoted bid and offer prices"

It's not in my interest to point out all of your errors, but I will say that writing "publicly quoted bid and offer prices" is nonsense. Prices are quoted bilaterally to existing counterparties. It's an entirely private arrangement.
Nothing public about it. Perhaps you will argue that TRADES in corporate bonds are recorded; fine, but that is not the same as making QUOTES public.

Tom said...

I'm leaning more towards the opinions contrary to your post. A few observations from 30 years in futures operations/ futures trading floors / etc:

Internal capture of order flow in an era of electronic markets does not mitigate volatility. It merely allows the 'market maker' inside the firm to capture what was previously considered the 'pit edge' (buy the bid - sell the offer). Market makers do not reduce volatility either. In fact, they're MORE likely to rush into or run screaming from a market than 'regular' investors $ traders. They are short-term money. And while the exchanges L O V E high frequency trading, I'm hard-pressed to discern how HFT is beneficial to the smooth functioning of markets and the general economic good - especially when there are firms riding the exchange pipe and able to front-run order flow....Regarding the big banks, while I would not have said to break them up, I DO believe that they should be allowed to fail. Now that they've been propped-up, I say dismantle them.....

On a separate topic, there's a fair amount of spam in the comments...just FYI. Perhaps giving moderation authority to a few regular contributors would help?

On still another topic, here's the latest in econo-thought:

http://outsidethe-cardboard-box.tumblr.com/post/249074091/the-new-australian-school-of-economics-wonkish

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