Big can still be beautiful in banking

Three research tomes emerged from the mighty house of JP Morgan last week – hundreds of page of investment banking commentary on an unlikely subject: Carla Antunes da Silva and her bank research team at JP Morgan were arguing that in banking, "big" can actually be "beautiful".

We might consider this to be a brave stance to take when regulators from New York to Sydney, and pretty much everywhere in between, are working on plans to make sure in future that we do not have banks that are too big to fail.

Banks whose failure would risk bringing down the financial system, as the straightforward argument goes, need to be cut down to size – otherwise there is a clear and present risk of moral hazard. Those running such institutions will act in a way that assumes that if they take too many risks, someone else will have to bail them out.

Yet da Silva and her team want us to take a more nuanced approach to the subject. She accepts that the size of banks may be an issue where the largest banks have the potential to lose a high percentage of a particular nation's GDP. This is particularly the case in Europe, she says, given the fragmented nature of the continent. But there is a need to see the sector in context:

"It is important, however, to recognise that size has a number of important benefits. Large banks have been an important facilitator of growth in both developed and emerging markets by financing the growth of their corporate customers and helping to intermediate savers and investors from around the world. In this report, we also show that the existence of large and well capitalised banks has helped to reduce costs for consumers. The diversification of many of these institutions has also helped to create stability and continuity by providing private rather than public sector solutions to distressed institutions."

The JP Morgan view is that the instability inherent in the financial system should be addressed by ensuring the national bank deposit insurance systems are stable and well-funded. Beyond that the research team would like to see the risk presented by the interconnectivity of the financial system addressed specifically, along with the risk of contagion in the modern global banking system.

"We think this is best achieved by regulating higher capital and liquidity ratios, which strengthen financial institutions and make them less likely to encounter distress in the first place, by legislating a clear recovery and resolution processes that provides optionality at times of distress and by encouraging the creation of sufficient pools of emergency liquidity funding as a backstop to the wholesale markets.

"We think regulators should avoid solutions which simply focus on size and scale and which introduce cost frictions which will damage the liquidity of markets and raise the cost of borrowing and they should prioritise those changes which most directly address the reasons for failure – leverage, poor underwriting and risk management and an over reliance on wholesale funding."

In investment banking, JP Morgan reckons that the current raft of regulatory proposals – such as the Volcker rule in the US – would see the typical return on equity at the world's leading investment banks collapse from 13.3 per cent to just 5.4 per cent. The analysts then estimate by how much prices of financial products would have to rise to make up this gap – in effect, to get corporate customers of banks to pay for the newly imposed regulation. The answer is 33 per cent on an average.

Now, critics of this approach would immediately say that the cost of regulation can be offset with lower pay cheques for the bankers themselves – so the bankers foot the regulatory bill, rather than their customers. However, JP Morgan argues that since compensation as a proportion of investment banking revenues has already fallen from from a typical rate of 45 per cent in the past to 35 per cent now, the pricing of financial products would still have to increase by a quarter to pay for all the regulation.

On one level this is entirely logical. There have to be costs to heightened regulation and those will inevitably suppress profit growth in the future. Then again, we can't treat this too seriously since da Silva and her team do actually work for a bank!

Note the chart on the left, showing the "decision tree" for dealing with a bank in crisis.

The point to note is that when a bank crisis is being addressed, private sector solutions are the first preferred method of support, such as a cash injection from existing shareholders. That is followed by "government assisted solutions", which might include a forced merger. Finally there are "government solutions" such as nationalisation.

JP Morgan's conclusion: You need big strong financial institutions to look after weaker peers when things get rough. To quote: "It highlights that in times of stress the private sector pays a critical role and that role is generally not played by small banks. It is played by large sophisticated financial institutions that have strong balance sheets and the management and operational bandwidth to step in and buy financially troubled institutions. Clients and society as a whole are better served in times of stress if continuity can be provided for the 'socially' important functions provided by banks. It is important to have 'healthy' banks that are in a position to purchase and continue operations of the failing institutions."

So yes, let's hear it for the banks!


- Paul Murphy is Associate Editor of the Financial Times. Views expressed are his own

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