Inside Financial Services

In Banking, Why Bigger Can Be Safer

The secret: diversification

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Darrell Duffie of Stanford may not realize it, but his defense of risk weightings on Bloomberg yesterday is really an argument for bigness in banking institutions. Duffie’s logic proceeds thusly: 1)Tossing out risk-weightings,as some regulators are now suggesting, would simply induce banks to reach for yield and thus court disaster. 2) Unfortunately, regulators tend to misappraise asset riskiness and have a particular weakness for sovereign debt.3) So when risk weightings are used, lenders often all pile into a relatively narrow range of “safe” assets. 4) When those assets blow up, everyone goes down together.See the problem? The professor gets at a solution:

An improved approach would recognize that, other things being equal, banks are likely to invest more heavily in assets with lower risk weights. This “piling on” can cause even a safe asset class to endanger a bank. Research I did . . . shows that it is relatively difficult for an adequately capitalized bank to fail from many small, high-risk loans unless they have a tendency to go bad at the same time. Given a failure, the culprit is relatively likely to be losses on very large loans to borrowers that had been judged safe. During the subprime crisis and the euro area’s sovereign-debt crisis, large loans with very low risk weights quickly became life-threatening. [Emph. added]I would translate “have a tendency to go bad at the same time” as “non-diversified” or, if I want to come off as wonkish,“correlated.” As Duffie notes, it’s safer for a bank to hold a diverse portfolio of higher-risk assets than it is to hold a monolithic portfolio of“low-risk” assets. The best way for a bank to weather a credit storm, then,would seem to be to ensure it is engaged in a wide variety of businesses, both lending- and non-lending related. Things like investment banking, payment processing, credit card lending, and mortgage servicing say. A broad geographical reach might also help!The model institution I’m describing sounds a lot more like, for example, JPMorgan Chase than First Bank of Paducah or, for that matter, Countrywide, does it not? This is one reason why the recent re-regulation of the banking industry is such a disaster: it artificially limits the businesses banks can engage in. The Durbin amendment puts a ceiling on debit-card fees. The Volcker Rule severely limits trading. In the end, banks will be less diversified rather than more so. And as Duffie’s work shows,that’s not a good thing for the financial system.What do you think? Let me know!

4 Responses to “In Banking, Why Bigger Can Be Safer”

  1. SWPilgrim

    The colateral issue is gross mispricing of risks, especially in the piling-on scenario.Adequate pricing at origination provides a gross margin that allows for adequate LLR at the onset of the credit and a trading margin for opportunistic disposal to a greater fool during it’s life. The heyday spreads of Greece versus Germany or Argentina versus Colombia were careless or just plain reckless; but then, its all OPM.

  2. Jeff

    Therein lies why the sector will remain relatively undervalued for the foreseeable future.

  3. oy

    Banks tend to pile into various ventures like lemmings, driving margins to the point where the rewards no longer mesh with the risks, and they do so because the government in the past would bail them out…..and all the more so the bigger they got. Big is therefore not better….if you are taxpayer or someone concerned about the stability of the economy as opposed to the stability of the CEO’s bonus.

  4. erb0813

    Banks spent years trying to get bigger and bigger, trying to be everything to everybody. The oil industry tried the same thing but has recently discovered that you can “grow by shrinking,” making shareholders more money by slimming down the business and running a “better”, not necessarily “bigger” operation. I believe banks are starting to get this and it will be the source of better bank earnings in the future.

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