Saturday, March 13, 2010

Too Puny to Succeed

Now that banking reform is beginning to be discussed in Washington, much of the conceptual discussion about new legislation surrounds “systemic risk” and “too large to fail” institutions.

Left behind is another structural challenge that faces regulators: “too puny to ever succeed”.

The FDIC puts out quarterly banking statistics, which are quite a good source for stat buffs like myself. LINK.

Here’s a tidbit: as of December, there were 8,012 banks in the US, with over $13 trillion in assets.

I know large numbers are difficult, so I’ll say it again: EIGHT THOUSAND BANKS.
That’s a lot of banks. I mean, how many banks do you really need? Obviously something very wrong happened on the way to industry consolidation.

The UK consolidated its banking industry in the early 20th century. Other countries, like Germany (with over 2,000 banks) have yet to see the shakeout. The US is on its way, with the total slowly coming down from over 14,000 in the 80s. But there is still a long way to go.

Here’s a pie chart with the banks by size.

What stands out here is that there are 2,845 banks with under $100 million in assets and almost 4,500 with under $1 billion. I know a billion sounds like a lot, but in terms of the total market, it represents less than 0.01%.

So we’re talking about a market where 92% of the market players are puny. Individually, they are tiny, minute, and perhaps insignificant. As a group, however, they control 11.5% of the system’s assets, including 17% of the real estate loans. (Can you say “systemic risk”?).

So what? You may say. More competition is great and it leads to greater efficiency. The fact is that in an efficient marketplace, these banks have no chance of long-term survival in their current form. Just think of the characteristics of the industry:

Retail banking has commoditized/standardized products and services. A checking account is still a checking account (even if people don’t write as many checks anymore).

Economies of scale exist. Processing two hundred transactions or whatever costs less per transaction than processing one hundred.

Technology has not only drastically reduced transaction costs (enhancing economies of scale), but is destroying the geographical barriers that protected the small fries. Let’s face it, do you really need to go the bank (branch) anymore? If a bank’s competitive advantage is being “close” to the consumer, how much closer than a click on your computer screen?

Close to 100,000 bank branches operate throughout the US, but although their number continues to grow (slower now), branches are shrinking in size and staffing. Last year, the WSJ reported that Bank of America was going to close 10% of its branches. The report was later denied by the bank, but you have to believe that the issue has been discussed in the bank.

BTW, just to get an idea, there are about 30,000 supermarkets in the US. Three bank branches for every one supermarket, seems a bit much, IMO. LINK

In any case, industry consolidation is now accelerated by the credit crisis. The FDIC can’t shut down these micro-banks fast enough. Of the 30 banks closed by the FDIC this year, 25 have total assets of less than $1 billion. Their challenge has been finding “less puny” and financially stable banks to absorb the operations of these failing banks.

So long Waterfield Bank, Marshall Bank, Evergreen Bank and Charter Bank (etc etc).
We hardly knew ye. You were too puny to succeed.


  1. I buy your contention that consumer banking should be an industry that benefits from the economies of scale. But in practice it doesn't seem to be that way: the large banks have huge fees; small credit unions and smaller banks tend to have lower fees. Why is that? Why aren't the large banks driving low prices?

  2. Right now there is little desire or need for the large banks to compete with the smaller ones on pricing such as fees. Big Banks have troubles of their own and are trying to generate as much profit as possible to deal with their loan portfolio problems.

    If you go to the quarterly report I linked, you'll see that -as a group- the large banks were the only ones to log a profit in Q4 of 09. They did it with higher fees (non-interest income) and lower costs (non-interest expenses) than the small guys.

    So basically, they are more profitable and not passing on the efficiency to the consumer (at least not right now).

    thanks for reading!

  3. Why isn’t the market working? Why hasn’t consolidation actually taken place?
    On the other hand, there are still several very large behemoths whose failure can drag the whole system down with them if they fail (again).

    Why should the banking sector be different from any other sector in terms of robustness? For example, if a small community bank fails, the system is not affected, but if a behemoth fails, the taxpayer has the pay the bill.

    Restaurants go broke every day, and nothing happens because the restaurant business is a robust system. Much like nature.

    If a large very large institution fails, then the taxpayer has to pay the bill and future generations pay for the mistakes of current bank executives.

    Even of you separate the utility from the casino, no single entity should be big enough to hold the rest of the economy and the government hostage.

    If there are too many small banks, let it be.

  4. Anon. thanks for reading and leaving your comments.

    I understand your points and agree with them mostly.

    However, you seem to be under the impression that there are no taxpayer or consumer consequences when a small or medium sized bank fails. That is not the case. Since the deposits at these institutions are insured, the FDIC must supply the difference between the recovery value of the bank's assets and the insured value of the deposits. That normally comes from the FDIC insurance fund, which is "funded" (lack of a better word), by premiums paid by the industry (and hence indirectly by the consumer) and, in the case it becomes depleted, from the Treasury (i.e. the taxpayer).

    The fund is already in the red and now relying on banks advancing premiums from years in advance. It's very likely that more banks haven't been closed because the FDIC simply can't pay for the bailout.

    If you read the press releases on most bank failures, the FDIC estimates how much it believes it will lose in each deal. A $200 million asset bank will typically cost around $50-60 million to the insurance fund.

    Multiply that by the likelihood of most smaller banks failing (if not now, sometime down the line due to competitive pressure) and the problem is large.

    If it were just the stockholders of the banks losing their investment, well, like you said, to heck with them. The deposit insurance is what changes the game for banks (as opposed to say, restaurants).

    Eliminate the insurance? Well, that's a whole different discussion.

  5. "Of the 30 banks closed by the FDIC this year, 25 have total assets of less than $1 billion."

    If more than 90% of all banks but only 83% (25/30) of the failed ones are puny, it means their rate of failure is better than the big banks: 25/7340=0.34% for puny banks and 5/672=0.74% for big banks, more than twice! Ha, take that! :p