With JP Morgan’s acquisition of Bank One, America can claim to be the home of two banks with assets in excess of $1 trillion each (the other being Citigroup). On a list traditionally dominated by foreign banks, US banks will now claim two of the top three spots. The US banking system is also becoming more concentrated, according to Minneapolis Fed chiefs Stern and Feldman. Whereas the top ten banks held only 17% of total bank assets in 1990, now the top ten hold about 44% of all bank assets.
So, we have the increasing size of US banks and a greater concentration of banking assets. Are these trends cause for concern?
The size of individual companies is of no concern in a free market. As Rothbard taught, the market naturally puts limits on the size of a firm or company, because there are limits of calculability in a market. Stated simply, the idea means that firms must be able to refer to external markets to rationally allocate their own resources. The more that these external markets are absorbed into one firm, the more difficult it will be to avoid losses and "greater will be the sphere of irrationality". Essentially, the argument is an extension of the Misesian notion that socialism, which is fundamentally one big cartel, cannot calculate.
But the banking industry is hardly free. What we are witnessing is the culmination of deposit insurance, fractional reserve banking, an undefined currency and a long trail of bailouts and other interventions into the workings of the world of money. The Fed—and by extension the US taxpayer—has become the reinsurer of the banking system, willing to bear the risk of catastrophe.
Michael Aronstein, cofounder of the famed Comstock Partners, used to say that all credit cycles end with a default by the biggest borrower. Though largely unthinkable beforehand, such a default becomes obvious in hindsight. Hindsight, unfortunately, gives little useful service except to obituary writers.
Given the increasing size of financial institutions, including Government Sponsored Enterprises such as Fannie Mae, and also given the concentrations, it may also be time to revisit the concept of too big too fail ("TBTF"). This is the idea that certain financial institutions become so large and so important that their failure cannot be allowed to happen without unhinging the financial system. Therefore, measures are taken to save the institution in question and may include the full protection of all depositors, as well as the suppliers of funds to the bank’s holding company, and perhaps may even include shareholders.
Traditionally, one of the Federal Reserve’s roles has been as the lender of last resort. This usually has applied only to troubled Banks. The idea of a lender of last resort grew out the accepted practices of European Banks in the 18th and 19th century, in particular the Bank of England. The most influential early advocate was Walter Bagehot who advised to "lend freely" in the face of crisis (though he added that such loans should be made on good collateral and at penalty rates of interest).
In what may be considered an early statement of the TBTF doctrine, Bagehot counseled, "In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failure is to arrest the primary failure which causes them." Therefore, a large bank, whose imminent failure would cause the failure of other banks, deserved rescue in this view. If allowed to fail, other failures would follow. The Fed has been involved, in a significant way, in a number of such rescues in its history.
Dr. Henry Kaufman recounts a few from his memoirs On Money And Markets, beginning in the mid-1970s. There was, for example, the Franklin National Bank (1974), the First Pennsylvania Bank of Philadelphia and the Continental Illinois Bank (1984). The Fed also came to the aid of several large banks in the 1990s by not enforcing certain rules and requirements with regard to capital and bad loans.
Therefore, it would seem reasonable to conclude that if JP Morgan or Citigroup should ever run into financial trouble it seems hardly likely that the Fed would stand by and let them become martyrs for the cause of free markets.
However troubling the bailouts of these banks would be, even just a cursory review of recent Fed history will show that the safety net has widened considerably. The Fed took on key roles in resolving the silver crisis in 1980 involving the Hunt brothers and took on a similar leadership role in negotiating the Long Term Capital Management settlement in 1998.
Internationally, and sometimes working hand in hand with the Treasury, the Fed was also involved in bailouts of Mexico (1994), South Korea (1997-98), and Brazil (1998). The IMF and World Bank depend on American money and their operations would certainly be crimped without Fed support and participation.
This itchy need to rescue failure is really bigger than the Fed itself. It extends to all government attempts to protect people from the consequences of their own actions.
Moral hazard is the term thrown about to denote the effect created when people are continually shielded from the consequences of their own errors. What happens is that this factors into their future decision making and they will tend to take greater risks in the future (and make more errors). Herbert Spencer, who wrote "The ultimate result of shielding men from the effects of folly is to people the world with fools," perhaps penned the most succinct and memorable expression of this phenomenon.
The gambling analogy always made sense to me. If you had a gambler whose pockets you continually refill every time he goes broke, this would certainly influence the way he plays the game in the future. Except in the case of financial institutions we are not talking about a gambler’s money, but we are talking about the savings of many people.
So, when looking at the rising asset size of America’s banks, such as the JP Morgan-Bank One combination, and in reading about increased concentrations, I see a rising future bill for the American people when the next big credit catastrophe occurs. Further, the continued fomenting of moral hazard ensures that the next big credit catastrophe will not be the last.
The solution to this problem is not to further tinker with deposit insurance regulations or capital requirements, nor does it include increased supervision of banking or modification of the myriad laws already on the books. What is needed is much simpler.
The ancient Greek philosopher Heraclitus gave us many bits of pithy wisdom, at least one of which is applicable to the TBTF problem. He wrote, "The Sun will not exceed its limits, because the avenging furies . . . would find out." Without a lender of last resort, depositors, as well as other creditors and investors would more heavily scrutinize the banks guided by the powerful motive of self-interest. They are the furies. But, they are listless today because they do not fear a real loss; their perceptions of risk have been distorted by the backing of the government.
Wringing out the moral hazard in today’s economy would take time and a lot of work, but essential to this process would be the credible severing of government backing of banks, as well as other institutions and businesses. The widening safety net must be pulled in. Release the furies.
