Is too much competition the problem with our banking system?

We all know the problem with the American financial system. It’s that a few institutions have become too big and interconnected to fail. And so, instead of letting creative destruction work its magic and purge the rottenness out of our financial sector, we’re engaged in a sloppy, counterproductive, hugely expensive effort to keep these ailing giants alive.

It’s a compelling enough story. Heck, I’ve bought into it from time to time. But what if it’s got things completely backwards?

For one thing, it doesn’t really square with the historical record: The U.S. had a rollickingly free financial system populated entirely by small-enough-to-fail financial institutions all the way through the 1930s, yet went through devastating financial crises every 15 -20 years.

It also doesn’t really square with the comparative success of the Canadian banking system, which evolved along the centralized, statist lines envisioned by Alexander Hamilton instead of according to the competitive Jacksonian model that prevailed here.

It also doesn’t really square with the evolution of the current financial crisis, which began out on the unregulated and extremely competitive fringes of the system and only hit the big banks relatively late in the game.

Maybe, just maybe, we would be better off with a heavily regulated, highly profitable oligopoly of large financial institutions. That’s the counterintuitive case John Hempton has been making in his blog for the past couple of days:

The standard dogma … is that competition is almost everywhere a good thing. But I would have the other view. My view is that competition in financial services causes massive financial crises.

You want fat, lazy banks, the reasoning goes, because fat, lazy banks don’t take crazy risks. You can still have a dynamic, competitive, innovative rest of the economy. But those traits only spell trouble in finance.

Stocks Rally Further in Run-up to EU Summit

MOSCOW — Global stocks enjoyed one of their best days in weeks on Tuesday ahead of a summit of European leaders that’s expected to be dominated by calls to boost economic growth.

Europe remains the focus of attention across all financial markets in the run-up to the June 17 Greek election that could go a long way to determining the country’s membership of the euro as well as the future of the single currency zone.

tc125231

This is probably rational. The Bell System may have been the most upright large American company of the 20th century.
They were heavily regulated and operated at cost plus, Nonetheless, Long Lines reduced the cost of service steadily for half a century, due to its R&D and long range planning. It was in their interest to do so.
One issue, however, is that the executives of that period didn’t expect to be compensated in the manner to which the current lot has become accustomed.
ambledge

Competition in banking results in some firms losing money and so the tend to gamble for resurrection. It’s one peculiar characteristic of the banking industry. The money you lend them — they’d rather go to vegas with it. Heads they win big, pay you a small interest; tails, that’s your problem (or the FDIC’s). So regulatory policy should be targeted to letting them have some profits and constrain their risk taking activities. Maybe banks shouldn’t be limited liability??? Maybe when we make a deposit, they should give us collateral!
leighblue

An interesting thought. Robert Peston on the BBC has just highlighted that Barclays has been given a clean bill of health by the UK regulators, and my conclusion was that this heralds a return to normal competitive equilibrium in the banking market – which, if true, is going to have huge positive effects. But this analysis is only focused on the short term, so in the long term you might be right.

Click here for Peston’s story and my thoughts on it:

http://www.knowingandmaking.com/2009/03/back-to-equilibrium.html
tagusco

The current implosion is the result of irresponsible underwriting of loans, passed up to be securitized so the defaults were somebody else’s problem, nurtured by lack of and/or unenforced regulation, excessive leverage, vodoo derivatives, extra low interest rates, unrealistic expectations and sheer greed. Practically nothing to do with excessive competition among banks!
tegwar

interesting thought. A predicate of competition is failure which is the root of banking crises. The problem (i.e. crises) isn’t really failure so much as synchronized failure… what causes that?