Large banks are created from the merger of individual banks, motivated by synergies, such as economies of scale, which often results to a group of banks becoming oligopolistic. Although this may be profitable for shareholders, customers and even the economy as well, the benefits are also limited to an extent, as the counter effects are tremendously risky, as the failure of one bank may result to the failure of the others and consequently the economy. Breaking up large banks, is considered as an endeavour to prevent such failure. In this essay, the advantages and disadvantages of such an approach will be discussed, relating to various economic theories.
In an attempt to answer the question; why are banks big? Altig (2010) explains that, big banks are created due to the efficiencies associated with getting bigger - economies of scale. To elaborate further, he mentions that, David Wheelock and Paul Wilson, of the Federal Reserve Bank of St. Louis and Clemson University, respectively, sum up what they and other economists know about economies of scale in banking:
…our findings are consistent with other recent studies that find evidence of significant scale economies for large bank holding companies, as well as with the view that industry consolidation has been driven, at least in part, by scale economies. Further, our results have implications for policies intended to limit the size of banks to ensure competitive markets, to reduce the number of banks deemed "too-big-to-fail"...
There is a long debate to be had about the maximum size to which a bank should be allowed to grow, and about how to go about breaking up banks that become too large. The issue can be examined from three perspectives; the economic efficiency that would be sacrificed by limiting the size of financial institutions, how such a policy affects systemic risk and, the political economy of limiting banks' size (Kling, 2010).
Stern and Feldman (2004) explains that the failure of a large banking organization is seen as posing major risks to other financial institutions, to the financial system as a whole, and possibly to the economic and social order. Due to such fears, policymakers in many countries respond by protecting uninsured creditors of banks from all or some of the losses they otherwise would face. Schultes (2010) adds that policymakers are united in their goal to prevent the rise of banks deemed too big to fail around the world. He noted that the US Senate voted through a raft of changes in the financial reform bill, stopping short of forcing a break-up of the country's largest banks. Meanwhile, in Europe there has been a preference for imposing higher capital requirements and caps on leverage to limit the growth in bank balance sheets.
The basic advantages of breaking up large banks can be said to be the perception of reassurance and security that follows, as there would be less fear that the failure of a group of banks will affect the economy of a country as whole. Healthy competition will be fostered between banks and will lead to better services provided to customers. In order to answer the question "Is bigger better for consumers?" Kling (2010) explains that bankers speak about the "financial supermarket" and claim that there are tremendous economies of scope in financial services, as a consumer benefits from being able to have a checking account and a stock portfolio at the same large firm. But in practice, whatever benefits might be derived from such a supermarket are probably more than offset by the diseconomies of managing such a complex entity. He adds that there are economies of scale, but small banks can take advantage of them, too. For instance, a small bank can join an ATM network or contract with a third party to develop Internet services. It does not have to build such systems from scratch.
However, Kling (2010) argues that exposed to the same risk factors, a system with many small banks could be as vulnerable as a system with a few large ones. Primary sources of financial risk have a way of ingratiating themselves regardless of the structure of the banking industry and in spite the best intentions of regulators. The issue of whether the breaking up of large banks is worth it and the disadvantages associated with this approach arise. Murphy (2010) states that "breaking up big banks could exacerbate risks within the global financial system by cutting down on the amount of diversification within the sector". Schultes (2010) adds that large diversified banks are good for market stability. Markets like Australia and Canada, where a number of large banks dominate, exhibited this during the crisis. Large banks efficiently use capital more compared to a collection of smaller institutions without economies of scale.
To control the adverse effect posed by large banks on the economy, Bofinger (2010) offers systematic capital risk charge that will depend on banks' size as a solution, he explains that this approach will be based on the theory of externalities, that suggest that "a polluter should be charged with a tax that is equivalent to the social costs of his pollution, assuming that the systematic instability created by a banks' activities is an externality". In his conclusion he states that the root of systemic risk is a lack of diversification. So, while taxes are an indirect way to cope with this problem, strict limits for large interbank exposures are the only straightforward solution. Acharya and Richardson (2010) stress the use of taxes as a solution. In their opinion as each financial institution attempt to lower such a tax, they will try to reduce their share of this risk, leading to a system-wide reduction in both asset risk held by these firms and their leverage.
Large banks will lose out on the various efficiencies and profitability resulting from economies of scale and scope, stability and safety, due to wide diversification of their services provided, when broken down. However, the resulting effect can be said to be a more stable and efficient economy, as banks will be operating in a healthier competitive market and minimize the amount of risk they take on, resolving the problem posed by banks that are termed "too big to fail".
