BIGGER BANKS, BIGGER PROBLEMS / CASEY ´S DAILY DISPATCH

Bigger Banks, Bigger Problems

Doug French

October 25, 2013 3:22pm

Warren Buffett says banks are in better shape than at any time he can remember. US banks have "built up capital, loan losses are down, portfolios are in good shape," the legendary investor claims. "The problem is they have more money around than they'd like."

That's one man's opinion from the outside looking in. But maybe things aren't so rosy. Richard Parsons was a banker with Bank of America and is the author of Broke: America's Banking System. The ex-banker has his doubts.


In a piece for the Wall Street Journal, Parson writes about the comments of FDIC head man Martin Gruenberg who said recently, "Prior to the recent crisis, the major national authorities here and abroad did not envision that these large, systemically important financial institutions (SIFIs) could fail, and thus little thought was devoted to their resolution."


Parsons takes Gruenberg to task for his lack of historical perspective. Indeed, during every rash of bank failures, big banks go down along with the small ones. As economist Murray Rothbard pointed out years ago, there is no other line of business where so many firms fail at the first sign of trouble.


In our fractionalized banking system, one person's deposits are loaned out to another, giving two people title to the same asset simultaneously. This is the fundamental reason that the banking system repeatedly fails in mass.

In an attempt to stave off repeated crises, the banking industry has enlisted plenty of help from the government. The Federal Reserve was created one hundred years ago to stand ready as the lender of last resort. The Federal Deposit Insurance Corporation, created by FDR, provides deposit insurance to quash any bank run.


Still, a run on only 8% of deposits put Washington Mutual, a huge mortgage lender, on the ropes.

The banking system melts down every couple of decades. Parsons points out that six of the top 50 banks failed in the banking crisis of the late '80s and early '90s. While many were allowed to fail, Parsons  quotes former FDIC Chairman Irvine Sprague who identified Continental Bank as "too big to fail," and wrote "scores of large and small institutions—perhaps hundreds—would have been in serious jeopardy if Continental could not have met its commitments."

Creating Monsters

Bank of America stepped in to aid regulators by acquiring two large failed Texas banks in 1988 and continued to buy failing banks over the next seven years. One of the banks was BoA's massive California competitor, Security Pacific. Amazingly, BoA paid over three times book value for a bank circling the drain. SP shareholders received the equivalent of $41 per share in 1992. Without the buyout, SP CEO Robert Smith estimates the bank's stock would have traded for $4 a share... probably on the way to zero.

As bailed-out institutions live on and grow larger, rescue operations balloon beyond the government's ability to handle alone. The bailed-out become the bailers-out. Bank of America stepped up again in the 2008 crisis and purchased the failing Merrill Lynch for $50 billion, and a teetering Countrywide Financial for $4.1 billion. The purchase of these bad apples continues to cost the company money.

Besides Bank of America, banking authorities asked Wells Fargo and JPMorgan to buy Wachovia, Washington Mutual, and Bear Stearns. With these transactions, Wells and Morgan grew into behemoths that cannot be allowed to fail.

Parsons' most salient point is, "Thirty of what were the 50 largest banks in the country in 1980 are now part of Bank of America, Wells Fargo, and JPMorgan Chase." By the end of last year, the top ten banks in the US now control 56% of banking assets. At the same time, the top 70 banks or 1% of the industry controlled 86% of deposits.

How on earth could stitching a bunch of bad banks together make bigger, safer banks? It can't, no matter what Warren Buffett thinks. Banks made $43 billion in the second quarter only because of a quirk in bank accounting rules that says banks don't have to count the $51 billion they lost in their bond portfolios.

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Parsons points out this country has seen 3,000 banks fail over the past three decades and more than 12,000 over the past century. As Rothbard explained years ago, the banking business is unstable and is doomed to repeat a series of booms and busts. Because of that, the financial system would be much safer if its assets were disbursed over as many banks as posible.

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Instead, at regulators' insistence, the problems and bad assets of many banks have been combined into a few. Instead of many small problems, we now have a few huge ones.

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Systemic risk in the financial system has increased, not decreased. As a result, whenever the next banking crisis hits, it will be a doozy.