The financial industry has witnessed a wave of mergers and acquisitions in recent decades, resulting in the creation of too-big-to-fail financial conglomerates. But can anyone claim that this has improved the economic function of finance? To create a robust recovery, writes Henry Kaufman, no issue matters more than preventing a further increase in financial concentration.
A broad transformation is underway in the structure of financial markets, both here in the United States and around the world. In the United States in particular, the degree of financial concentration has increased sharply in recent decades.
It got a substantial boost with the demise of the Glass-Steagall Act in the 1990s. To its discredit, the U.S. Federal Reserve neither opposed, nor recognized the long-term consequences of, the end of Glass-Steagall, the 1933 act of Congress that separated commercial banking and investment banking.
During the 2008 financial crisis, financial conglomerates that had bought up many financial institutions in the preceding decade gobbled up even more. And once the crisis hit in full force, many of the smaller institutions failed. Unlike in the case of the larger institutions, they were not bailed out by the government.
As a result of all these moves (before the crisis, during the crisis and afterwards), a very high proportion of U.S. financial assets are now held by a mere handful of conglomerates. And they are the ones deemed "too big to fail." Smaller firms operate ever more on the margins and hold only a declining share of financial assets.
Several figures help illustrate how far we have lurched toward financial holding concentration:
In the 1980s, the five largest U.S. banks accounted for 29% of total banking assets, or 14% of U.S. GDP. Today, they account for more than half of total assets, or 86% of GDP.
Five banks — JPMorgan Chase, Bank of America, Goldman Sachs, Citibank, and Wells Fargo — currently represent 96% of the notional amount of all derivatives.
In 2009, the four biggest banks originated 58% of all mortgage loans and controlled 57% of credit card purchase volume.
In investment banking, many of the most prominent heritage names are no longer independent, or have disappeared altogether: E. F. Hutton, Kidder Peabody, Paine Webber, Dean Witter Reynolds, Merrill Lynch, Salomon Brothers, First Boston, Shearson Lehman, Drexel Burnham, Bache & Company and Bear Stearns.
One notable example of consolidation through merger is JPMorgan, which has been in the headlines recently with its problems concerning internal risk management controls. Its holding company structure now includes such prominent former institutions as Chemical Bank, Manufacturers Hanover Bank, Chase Manhattan, Bank One, Bear Stearns, Washington Mutual and First Chicago.
Now, how can anyone state with reasonable objectivity that these amalgamations have improved the efficiency of financial intermediation — that is, the effective allocation of credit? The market-making power of these few remaining institutions is staggering.
Consider, for example, how many fewer dealers are available to execute a trade today, as compared with a decade ago. And as the number of market makers decreases, so does the depth of the secondary market. Meanwhile, market volatility increases.
The rolling-up game
Financial concentration has other unwelcome consequences as well. It privileges large-firm over small-firm financing. The incentives for branch managers to serve their local community are relatively weak. Managers with ambitions to climb the corporate ladder will seek out big-firm financing, even if it means jumping ship to a larger employer.
Financial concentration also complicates monetary policymaking. When conditions call for monetary constraint, which firms will be affected the most? Surely not the too-big-to-fail giants, which will be largely insulated from central bank restraint. Rather, the smaller firms will feel the brunt of Fed tightening.
As a consequence, some will fail or be forced to consolidate with their larger counterparts. The result? Even greater concentration.
The Dodd-Frank legislation hopes to cope with the inherent challenges by calling for the orderly dissolution of any too-big-to-fail institution that might become financially vulnerable.
The official designation of "too big to fail" places much of our financial markets under the direct control of government authorities. A very large and complex official supervisory network, led by regulators in Washington and London, is now being put in place.
These bureaucratic networks will undoubtedly have great influence over the allocation of credit. But this process will be much more difficult to orchestrate than the authorities imagine.
Just consider that these conglomerates hold securities and participate in markets with other institutions around the world. How would these millions of positions be unwound to the satisfaction of all parties?
It is also reasonable to assume that most of the assets and liabilities of the failing firm would be acquired by one or more of the surviving behemoths — that is, by one of the too-big-to-fail institutions — or by the government itself.
The result? Even greater financial concentration. It is as if the rolling-up game, once started, knows no end and no boundaries.
It is, of course, possible that new technologies will erode some of the dominance of the huge financial conglomerates. Perhaps in the future the entire deposit function will be handled by some giant cloud computer facility controlled and guaranteed by the government.
At a minimum, it is hard to imagine that children born today will write checks, make deposits or withdraw funds as most of us do today. The thousands of bank branches that dot the landscape will be converted into other kinds of businesses.
Similarly, the armies of financial advisors will be disbanded if a lasting financial recovery fails to materialize and boost the savings of the entrepreneurial middle class.
These are real possibilities. This makes me wonder even more why major governments around the world continue to favor financial concentration (while failing to actively oppose concentration in nonfinancial sectors as well).
All of that leads me to point to a development that is unforeseen by most and considered heretical by many, especially those at the pinnacle of the financial industry: It seems more and more likely that the future will be one in which credit is socialized and our major financial institutions are financial public utilities. And, increasingly, this will be a global phenomenon. It will diminish economic and financial efficiency and entrepreneurship generally.
Before we get there, however, we will be forced to contend with a financial structure in the interim that will constrain both our financial freedom and the effective allocation of credit.
**Editor's note: This article was adapted from the author's remarks at the 21st Annual Hyman P. Minsky Conference in New York City, on April 11, 2012. The conference was organized by the Levy Economics Institute of Bard College with support from the Ford Foundation.