Why Big Banks are bad for the economy.

For many years we have heard the mantra that we have too many banks; We need consolidation of the banking sector. But this is FALSE. While it is true that big banks can lower transaction costs, these costs are a minor part of the cost of banking. The major cost is loan losses. In controlling loan losses, the big banks perform significantly worse than small banks. This post will first show this is true and then show why the consolidation in the banking sector is a key reason for the economic crisis.

First, big banks have higher loan losses. The Fed of St. Louis has a database that aggregates the loan losses by size of institution. Let's look at the small banks loan losses:

You can see range for the small banks is ~.01 to ~1.05. Note the current loan losses at .4. Now for comparison let's look at the largest banks:

Notice the scale on the left is about twice that of the small banks and currently is about 1.5%. At NO time has the small banks had a loan loss rate at the current rate of the big banks! The simple fact is the larger the bank, the higher the loan losses.

Still not convinced? Look at the intermediate banks and they show the VERY same trend:


And the larger medium banks:



So you can see that as banks grow bigger than have higher loan losses. Why might this be true?
1) As a bank grows bigger, it is harder and harder to evaluate the credit risks of companies. Often credit risk is not a simple formula, but experience and knowledge of local markets. A local hardware store may look fine on paper, but have rotten parking. Thus, everything looks good on paper, but a bad location is hard to evaluate from hundreds of miles away.
2) Risk aversion. The larger bank personnel are paid more the larger the bank. The bank has an incentive to grow at higher rates and take on more risk. In a large organization, you can 'bull-shit' away many bad credit decisions. If you have the 'right' politics, you can escape blame. Thus, many managers will take on more risk the bigger the organization. As a bank grows bigger they have higher rewards, lower risk to the bank officers for taking risk. Multi-levels and multi-lines of authority make pinning bad decisions on individuals harder the bigger the organization.
3) The larger the bank, the greater the distance between an individual decision and real results on the bottom line. In a small bank a million dollar loan gone bad will impact the stock price. In a big bank, a million dollar loan gone bad will have no impact on the stock price. Thus, a bank manager in a small bank is very careful, while a bank manger in a big bank has far less incentive to be careful. The larger the bank, the more difficult it is to make every employee responsible.

In the past 10 years, the consolidation of the banking sector has lead to the increased size of banks. This in turn has lead to more loan losses. Currently, the losses at the largest banks are threatening the entire banking system. But this should not come as a surprise, because as a bank gets bigger the loan losses increase. The banks have gotten WAY bigger and thus the loan losses have increased. In order to prevent future loan losses, we need to break up the large banks and return to smaller banks.