Big banks bad, small banks worse

Felix Salmon has this to say:

Earlier this week, Matt Yglesias wrote a post about what he calls “America’s Microbank Problem”: this country has far too many banks, he says, and they’re far too small. A rebuttal soon came fromRob Blackwell of American Banker, who called Yglesias “dead wrong”. This is an argument which clearly needs to be adjudicated! And in this case, I’m afraid, Blackwell wins.

Salmon is taking the easy option here, but Yglesias is clearly right.  I’ve been bashing small banks for years, but no one pays attention.  So I’ll have to do it again.

As for the idea that FDIC insurance makes small banks riskier “” well, that’s just bizarre. The FDIC crawls all over small banks, precisely because it has so much at risk. And because small banks have simple operations which are easy to understand, the FDIC can and does step in early when they start getting into trouble. Effectively, small banks have the better of two management teams: the in-house one, or the FDIC. And the FDIC knows what it’s doing. 

Nope, FDIC creates moral hazard on steriods, which is one of the reasons why we have had two major small banking fiascos in the past 35 years, once in the 1980s and once again after 2008.  Both had the same cause, small banks took advantage of FDIC-insured deposits to shovel lots of loans to developers of risky projects in sunbelt states.  Heads the banks and developer cronies win; tails the taxpayer loses.

What’s more, if the FDIC ever has any difficulty regulating these banks, all it needs to do is raise its dues to make up for the extra risk that it’s facing. Essentially, the US banking system regulates itself: the dues from profitable banks go towards rescuing troubled banks. The rest of us never need to worry. Except, of course, when the bank is so big that the FDIC can’t afford to let it go bust. It’s the too-big-to-fail banks which are the real problem, not the little ones.

Just the opposite, the big banks are a problem but the small banks are much worse.  The FDIC fees on the good banks are a tax passed on to bank customers, just as surely as a tax on gasoline or cigarettes is passed on to customers.  I pay via more costly bank services in Boston to bail out overcompensated depositors of shady banks in Georgia.  So I do “need to worry.”

Smaller banks can pose a systemic risk, as we saw in the S&L crisis.

As we saw in the S&L crisis and as we saw in the very similar 2008 crisis.  Yes, the big banks were also irresponsible in 2008, but at least they repaid their TARP loans.  The FDIC money shoveled to small banks is money down the drain, a loss to taxpayers.

We’ve had three banking crises in the past 100 years while Canada (a country without small banks) has had zero.  The political power of the small banks played a major role in causing the Great Depression, which led directly to WWII.  Small bankers who lobby Washington for special favors have blood on their hands.

Kudos to Yglesias for not taking the easy populist approach to banking.

HT: TravisV



33 Responses to “Big banks bad, small banks worse”

  1. Gravatar of Frances Coppola Frances Coppola
    6. December 2013 at 16:59

    Well said!

  2. Gravatar of Brett Brett
    6. December 2013 at 17:18

    The article that Salmon cites, while defending community banks, also points out that they get their best returns in the $1-10 billion range of assets holding. If most of the smaller banks consolidated into a couple hundred to a thousand banks of that size, we’d be a lot better off.

  3. Gravatar of Al Al
    6. December 2013 at 17:25

    How is the additional risk of smaller banks exhibited? Before 2007, smaller banks show lower charge-off rates, higher net interest margins, and higher equity/assets.

  4. Gravatar of ssumner ssumner
    6. December 2013 at 18:09

    Thanks Frances.

    Brett, That sounds right.

    Al, The only risk I care about is the risk to the taxpayers. I can’t answer your question.

  5. Gravatar of Morgan Warstler Morgan Warstler
    6. December 2013 at 18:49

    Scott swings and misses.

    If the problem is FDIC, the problem is FDIC.

    In order to fix it, I’d let ANYBODY be a bank, something like covestordotcom – make him put up $50K of his own money, grant his depositors FDIC, and REDUCE FDIC coverage in any one bak to $25K.

    Yes, it is better to have no FDIC.

    So it LOGICALLY follows:

    Scott is wrong to put up with it.

    The preferred policy will either ruin it, or feed my tribe and clan with it.

  6. Gravatar of Doug M Doug M
    6. December 2013 at 20:18

    The only risk I care about is systemic risk.

  7. Gravatar of dtoh dtoh
    6. December 2013 at 20:55

    There are two solutions. Eliminate the guarantees (FDIC and TBTF) or give the Fed the power to flexibly set maximum and minimum asset/equity ratios by assets class, maturity, etc.

    Given that there is no way politically that the guarantees are going away. The only solution and the easiest solution is to have the Fed regulate asset/equity ratios more stringently.

    This is so obvious!

  8. Gravatar of Ralph Musgrave Ralph Musgrave
    7. December 2013 at 02:38

    According to the chart here (link below)it was the big banks that were responsible for the recent crises:

  9. Gravatar of Saturos Saturos
    7. December 2013 at 02:40

    Are you making a prediction here that banks would consolidate under free banking?

  10. Gravatar of Geoff Geoff
    7. December 2013 at 06:10

    Inflation is a moral hazard.

    NGDPLT would require a continuous series of bank bailouts (in the form of trading assets for a higher price than otherwise), because the Fed would have to increase the money owned by the banks if it is going to target total spending in the face of the public deciding to increase their money holding times.

    NGDPLT would carry a moral hazard. The more the public waits before spending, the more flush with new reserves the banks will experience. Note that it is not an argument against this to point out that banks will have to give up treasuries or other assets if they want money. The very fact that they are willing to trade their assets for money, time and time again, proves that there is a higher value on the money, than on the assets. This gain is where the moral hazard resides.

  11. Gravatar of Tommy Dorsett Tommy Dorsett
    7. December 2013 at 06:40

    Scott, you said, ‘The political power of the small banks played a major role in causing the Great Depression’.

    Can you extrapolate, please?

  12. Gravatar of ssumner ssumner
    7. December 2013 at 06:58

    Morgan, I’m all for trimming back on FDIC.

    dtoh, Agreed, although there is some debate about whether those regs could be evaded.

    Ralph, That graph tells us nothing at all about who was to blame for the crisis. Where is the Fed in that graph?

    Saturos. I would never put money in a small bank without FDIC. Too risky.

    Tommy, Experts wanted to move toward a Canadian-style system with branch banking, but the small bankers stopped the reform from happening. Canada had no bank failures in the Depression, we had about 5000. The US banking crisis played a huge role in the Great Depression.

  13. Gravatar of John Thacker John Thacker
    7. December 2013 at 07:04

    “Sunbelt states,” Scott? In the 1980s, yes, but there was much less volatility (and bad loans, since related) in say, TX or NC in 2008 and since than in states like MD, WA, and others no one would call “Sunbelt.”

    The set of states strongly affected by the bad loans in the 1980s S&L and in 2008 are pretty different.

  14. Gravatar of Brian Donohue Brian Donohue
    7. December 2013 at 13:12

    The link between small banks and WWII is absurd and undermines an otherwise fine post.

  15. Gravatar of ssumner ssumner
    7. December 2013 at 18:33

    John, I was under the impression it was mostly southern states, plus Illinois. Is that wrong?

    Brian. Which part? The part connection banking with the Depression? Or the part connecting the Depression with WWII?

  16. Gravatar of dtoh dtoh
    7. December 2013 at 18:45

    Scott, you said:
    “dtoh, Agreed, although there is some debate about whether those regs could be evaded.”

    Scott, do you have any specific examples. In a past incarnation, I had a lot experience with both the original BIS regs and with a variety of financial products. I’m pretty sure it’s easy. Simple Rule #1. When in doubt… 100% equity required.

  17. Gravatar of dtoh dtoh
    7. December 2013 at 18:48

    Clarification. Regulation (not evasion) is easy.

  18. Gravatar of Floccina Floccina
    7. December 2013 at 19:23

    Great post. It is worse a big bank failing than a few small banks that combined are as bid as big bank failing.

  19. Gravatar of Andy Andy
    8. December 2013 at 05:51

    Yes, FDIC insurance is a tax passed onto bank depositors and other creditors (not consumers of other banking services). Don’t forget that you are getting federal deposit insurance in return! So perhaps its more like a “fee.”

  20. Gravatar of Andy Andy
    8. December 2013 at 05:58

    With regard to the most bank failures: GA and FL led the way. There were a lot in IL and CA as well. Those four states combined for 52% of total bank failures. A lot of it comes down to which states had a lot of small or de novo banks due to a combination of history and aggressive growth during the boom years.

  21. Gravatar of Brian Donohue Brian Donohue
    8. December 2013 at 06:11

    Scott, the second part. I don’t see US policy toward small banks putting Hitler in power, or driving Japan to invade China.

  22. Gravatar of Orn Gudmundsson Jr Orn Gudmundsson Jr
    8. December 2013 at 07:32

    Yglesias is wrong and Scott is right, but for the wrong reason.

    1) “They are poorly managed” and “finance themselves almost entirely with loans from…depositors”.

    He gives no evidence of bad management (only some reference that all smart qualified people are on Wall Street), and is also wrong on funding. The smaller banks are less likely than the larger ones to be more heavily deposit funded for their loans. In fact, the biggest problem small banks have is obtaining deposits to fund loan growth.

    2) “They can’t be regulated: Since these banks are so small…”

    Since these banks have relatively simple portfolios, they are probably easier to regulate, even weight adjusting for loan size.

    3) “They can’t compete…” They are competing for different business. Perhaps, you can construct a scenario where the larger banks fill the gap, but they seem not to want to. As to how the existence of small banks allows the larger players to “monopolize big time finance”, I just don’t get it.

    Scott is right that the problem is the FDIC, but it is really not the deposit insurance (sure it is a moral hazard, although it is just as much of one in larger banks that are self-funded by deposits and one that won’t go away, I can make a strong case for smaller banks being easier to understand and more prevalent in an insurance free world). Instead, the problem is the types of loans the FDIC pushes on the smaller banks. Smaller banks end up more heavily dependent on real estate as collateral because it is easier to get the regulators comfortable with loans which are “over-collateralized” with appraisals. That is, even when a community bank loan is to a small manufacturer, mostly they are collateralized by the owner’s personal guarantee and the property of the business (which are both likely heavily weighted to real estate). So, the problem is the FDIC, but it is really the types of loans that the regulators allow.

  23. Gravatar of Benny Lava Benny Lava
    8. December 2013 at 07:34

    Wait, so the FDIC creates a moral hazard with small banks, but small banks created the Great Depression before the creation of the FDIC? This doesn’t really make sense. If small banks make risky loans that cause panics before the FDIC why would you assume the FDIC causes small banks to make risky loans?

    And doesn’t this line of thinking really contradict your previous line of work that states that tight money caused the Great Depression and the Great Recession? If we are looking at causality isn’t it the opposite: tight money caused small bank loans to sour and small banks to fail. They only look risky as a post hoc rationalization.

    Maybe economists shouldn’t moralize the economy.

  24. Gravatar of ssumner ssumner
    8. December 2013 at 08:04

    dtoh, I recall that people claimed banks got around the Basel 2 standards.

    Andy, What do you think of the “fee” placed on gasoline purchases?

    And thanks for the info on banking, that was my impression.

    Brian. There is no question at all that the Great Depression put Hitler in power. His party was going nowhere in 1929, by 1933 he was in power. The Depression made the German electorate turn to radical parties in desperation.

    Orn, Good points, but I disagree with FDIC being just as big a problem for large banks. There are more diversified and hence moral hazard is less of a problem.

    As late as 1929 there was talk of creating an EU in Europe.

    Benny, You said;

    “Wait, so the FDIC creates a moral hazard with small banks, but small banks created the Great Depression before the creation of the FDIC? This doesn’t really make sense. ”

    Some of us are capable of thinking about more than one factor at a time. Others cannot.

  25. Gravatar of James in London James in London
    8. December 2013 at 08:16

    If you don’t like the FDIC “tax” then put your money into some non-FDIC-insured deposits and get a higher return. But I suspect you wouldn’t like the trade-off if you think small banks too risky, I guess you must prefer TBTF banks.

    The 2008 banking crisis was actually started when non-FDIC insured depositors started facing losses at some large banks like Indymac and WAMU and, quite rationally, fled. What caused the difficulties that led to the loss in confidence at these large banks is the Fed accidentally collapsing NGDP and the housing market.

    Abolishing the FDIC and putting all deposits on a level-playing field is the right way forward, Encouraging well-funded deposit insurance schemes for idiosyncratic bank failures is also a good idea. For systemic failures, only the Federal Reserve can help, even if, paradoxically, it is often the cause, too.

    However, the biggest mistake in your post may just a confusion about numbers. More small banks fail because there are, well, more of them.

  26. Gravatar of Benny Lava Benny Lava
    8. December 2013 at 11:04

    Well if that’s how you feel.

  27. Gravatar of ssumner ssumner
    8. December 2013 at 11:21

    James, That’s true of all taxes. If you don’t like the tax on petrol you can ride a bike. Yes, other assets are closer substitutes, but it’s still a tax. I do agree with your suggestion that FDIC should be abolished.

    Benny, Sorry if that was snarky. No, it doesn’t contradict my earlier comments. The bank failures cause money to get tighter under a gold standard.

  28. Gravatar of James in London James in London
    8. December 2013 at 12:23

    Cars vs bikes is not the right comparison. You can’t drive a car without buying taxed petrol. You can make a deposit without buying a deposit product incurring the FDIC 10-15bps fee. You just don’t think it’s worth the risk. 15% of depositors, by value, don’t get the guarantee.

    The US has plenty of other cranky financial issues, like most mortgages being funded by securities guaranteed by state agencies. Securities that then mostly get bought by the state’s central bank. I know this latter step is monetary policy, but the whole thing is a terribly convenient system for the big private sector banks who take most of the benefit, and who are deafeningly silent about changing anything. And probably lobby to not rock the boat (gravy train/pork barrel).

    Big banks are far worse than small banks when it comes to arbitraging prudent regulation. Professors in ivory towers should get out on a bank trading floor once in a while and see the multiple ways in which traders at big banks get around attempts to restrict their use and abuse of leverage.

  29. Gravatar of ssumner ssumner
    8. December 2013 at 18:50

    James, Those are good points, and I’m sure we’d mostly agree on the optimal regulatory structure. Maybe part of the difference is that America’s banking system has a slightly different set of weaknesses from the UK, reflecting our different history. I’d guess here’s it’s more the legacy of branch banking prohibitions, and in Britain it’s somewhat bigger banks taking advantage of regulatory arbitrage possibilities.

    But I still say it’s a tax, in a free market FDIC would be structured very differently. A better analogy might be that in many states one can avoid the cigarette tax by purchasing tobacco and “rolling your own.” Just a minor inconvenience, like going to a non-bank. But people go to banks despite the costs of FDIC being passed along, so they must offer something.

  30. Gravatar of James in London James in London
    9. December 2013 at 13:04

    Essentially, people don’t care which bank they go to. All they want is the FDIC guarantee. It’s the same the world over, wherever a state-backed guarantee operates. Banks like to make out people choose a bank for positive reasons, like normal consumer goods. But banking is an unpleasant essential, almost an anti-good, like commuting to work. You do it because you have to, not because you want to.

  31. Gravatar of TallDave TallDave
    9. December 2013 at 14:35

    It’s rare anyone convinces me to side with Yglesias, so kudos to Scott.

  32. Gravatar of TravisV TravisV
    9. December 2013 at 15:02


    I hate to hear you say that because I find both you and Yglesias to be incredibly smart….. 🙂

  33. Gravatar of LK Beland LK Beland
    10. December 2013 at 11:06

    About Canada having no small banks, that’s not quite true. There are about 80 federally insured banks in Canada:

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