big banks vs small banks

[ERICOPOLY]

I don't get why people are against TBTF banks, wanting to break them up.

 

BofA will have a SIFI buffer of 2%.  If you broke it up into 100 pieces, you'd have 100 banks with exactly the same loans but without a SIFI buffer.  The system would be more leveraged.  How many small banks failed last year?  How many TBTF banks?

 

For a bank like BofA, you have regions of the country where they are very profitable, and those profits cover the losses for the regions of the country where losses are enormous.  Split it up into 100 parts, and you'll have the FDIC covering the losses of the banks concentrated in the struggling regions, and the banks concentrated in thriving regions will keep all of their profits to themselves with no losses to subsidize.  So the FDIC suffers if you break up BofA, whereas BofA absorbs all of the losses if you keep it whole.

 

If the entire system were just one large enormous bank, then last year the FDIC would have lost nothing at all.  Not one dollar of losses!  It's the small banks that create risk for the FDIC.  The banking system in the aggregate had a very profitable year last year.

[rranjan]

What you said is true but smaller banks can fail without creating huge risk for whole financial systems. These TBTF banks had their hands in too many things, creating too much dependencies with financial system as a whole.  It will be difficult to imagine the impact if they fail and not too many people are interested to find out the impact in reality. As result, we got this name - TBTF.

 

FDIC taking some hit is not a nightmare scenario. Also, as you explained , BAC as a whole might have higher chance of survival. But price of failure is too high even with smaller chance of failure. I think the focus on them comes mainly due to this reason. I personally don't think we can get rid of TBTF scenarios.

 

[ERICOPOLY]

I was also thinking about the "special" FDIC assessments that the TBTF banks had to pay.

 

Ironically, they aren't the ones putting stress on the FDIC!  The TBTF banks are covering their own bad loans, and the tiny community banks are the ones failing by the hundreds.

 

This creates a moral hazard.  The small banks that carry the risk pay a smaller share of the FDIC burden.

 

TBTF banks will also, by definition, never draw on the FDIC reserves.  They instead are forced to lug around their big rainy day bailout fund (the SIFI buffer) -- you can think of this like a privatized extension of FDIC fund.  Sort of like being forced to tow your own depositor rescue vessel behind you, yet at the same time being required to cover the costs of the deposit bailout fund (FDIC) that by definition you're not expected to ever make use of.

[bookie71]

For me it is because it is so much easier to analyze a small local bank.  I know the local economy and can better evaluate the reserves, which to me is the key and their margin of safety. The bankers call it home town knowledge.

Now big banks, do you know who they are lending to?  Do they have loans in Greece, Italy, etc.?  I just can't get comfortable with them.

I can drive around town and see which local banks are financing which projects, and by listening to folks get an idea who is in trouble.

[bmichaud]

I was also thinking about the "special" FDIC assessments that the TBTF banks had to pay.

 

Ironically, they aren't the ones putting stress on the FDIC!  The TBTF banks are covering their own bad loans, and the tiny community banks are the ones failing by the hundreds.

 

This creates a moral hazard.  The small banks that carry the risk pay a smaller share of the FDIC burden.

 

TBTF banks will also, by definition, never draw on the FDIC reserves.  They instead are forced to lug around their big rainy day bailout fund (the SIFI buffer) -- you can think of this like a privatized extension of FDIC fund.  Sort of like being forced to tow your own depositor rescue vessel behind you, yet at the same time being required to cover the costs of the deposit bailout fund (FDIC) that by definition you're not expected to ever make use of.

 

I have yet to read/hear a good explanation as to what makes something TBTF. BAC has $120B of tangible equity and $350B of total debt (I'm approximating off the top of my head), which means it has roughly $470B of capital available to absorb any losses before depositors are hit and depositors are insured anyway up to $250K. What am I missing? Counter parties have netting and collateral posting requirements. Isn't the only requirement of the Fed in a "failure" scenario to backstop liquidity and payment systems? I would love an explanation as to why bond holders losing their investment is a risk to the global financial system in a BK scenario. Global equity and bond investors took a BATH from the fall of 2007 to March of 2009 in the form of widening spreads and collapsing equity markets. Why dont we just consider all "risky" investments TBTF?

[bmichaud]

I hear what you're saying, but when you think of it from a micro level, I don't see the problem. Deutsche Bank had something like $2B of exposure to Greek CDS, for example - let's say that was ten times larger but spread throughout the system with ten different institutions, that should be manageable on an individual company basis.

 

I've heard El Erian talk about the big problem with Lehman was the "payments" system - I would think this combined with the "inter-relatedness" could be backstopped by the Fed, while allowing bondholders to fail. If the bondholders are allowed to fail and the Fed backstops the payments/inter-relatedness, and the system STILL collapses, then TBTF exists.

[Vish_ram]

The main reason is human behavior. You have to minimize the spread of panic and its effect on consumption and consumer confidence. If mom and pop bank fails, most people would hardly notice. If a big bank fails, you'll hear it in every news media. Millions of people are directly/indirectly impacted and talk about it.

 

We live in a new world where many banks are a twitter post away from a bank run.

 

TBTF should be rechristened as TDTF (too dumb to fail) and FED should monitor the dumbness of management to decide how big they can get.

[HJ]

I hear what you're saying, but when you think of it from a micro level, I don't see the problem. Deutsche Bank had something like $2B of exposure to Greek CDS, for example - let's say that was ten times larger but spread throughout the system with ten different institutions, that should be manageable on an individual company basis.

 

I've heard El Erian talk about the big problem with Lehman was the "payments" system - I would think this combined with the "inter-relatedness" could be backstopped by the Fed, while allowing bondholders to fail. If the bondholders are allowed to fail and the Fed backstops the payments/inter-relatedness, and the system STILL collapses, then TBTF exists.

But it's the TBTF banks that are willing to make certain bets (or according to them, obligated to make certain markets), specifically, in the world of derivatives (a world invented, and encouraged to flourish by them within the last 30 years).  There was recently article about Morgan Stanley getting $3.4 billion from Italy to unwind a swap transaction and booked $600 MM gain in 4th quarter.  Now what if Italy actually did default?  Morgan Stanley would be on the hook for $3.4 billion, just from the one transaction that became known.  The top 10 institutions in the world account for something like 90% of the derivative notionals outstanding.  Italy being the 3rd largest sovereign issuer, derivative notional outstanding with them as the counterparty runs into the hundreds of billions at a minimum, and that's just on the more plain vanilla interest rate kind, let alone the more exotic credit derivative side bets.  And once you question the credit worthiness of counterparty, it's gross, not net notional that matters.  If you measure the gross notional on JP Morgan or Deutche, I bet the number goes into the trillions.

 

The fact that the TBTF's can still keep derivatives off exchange, and make that their exclusive casino with little disclosure is quite bizarre.  Cause that really continues to be the weak link.  Think how many horror stories you've heard over the years, from Jefferson County to Greece to Italy.  And if we have a dramatic rising rate environment ala 1970's, you'll have a different set of players blowing up, think Orange County, all with the TBTF's as their counterparty.  It makes you really question the wisdom to have this market exist at all, as all these transaction does is redistribute the risk within the system, and give certain players a perceived hedge against rate movements, while they all took the credit risk of TBTF's.  There is no net reduction of rate risk to the system.  The only way for the entire system to reduce the rate risk is for the system to pay down debt, which certainly ain't a good thing for the financials. 

 

All this rant is just to say that if TBTF's all just behave like a bigger version of US Bank, then it's one thing, but they don't, and therefore it's another thing all together.

 

 

[Morgan]

But it's the TBTF banks that are willing to make certain bets (or according to them, obligated to make certain markets), specifically, in the world of derivatives (a world invented, and encouraged to flourish by them within the last 30 years).  There was recently article about Morgan Stanley getting $3.4 billion from Italy to unwind a swap transaction and booked $600 MM gain in 4th quarter.  Now what if Italy actually did default?  Morgan Stanley would be on the hook for $3.4 billion, just from the one transaction that became known.  The top 10 institutions in the world account for something like 90% of the derivative notionals outstanding.  Italy being the 3rd largest sovereign issuer, derivative notional outstanding with them as the counterparty runs into the hundreds of billions at a minimum, and that's just on the more plain vanilla interest rate kind, let alone the more exotic credit derivative side bets.  And once you question the credit worthiness of counterparty, it's gross, not net notional that matters.  If you measure the gross notional on JP Morgan or Deutche, I bet the number goes into the trillions.

 

The fact that the TBTF's can still keep derivatives off exchange, and make that their exclusive casino with little disclosure is quite bizarre.  Cause that really continues to be the weak link.  Think how many horror stories you've heard over the years, from Jefferson County to Greece to Italy.  And if we have a dramatic rising rate environment ala 1970's, you'll have a different set of players blowing up, think Orange County, all with the TBTF's as their counterparty.  It makes you really question the wisdom to have this market exist at all, as all these transaction does is redistribute the risk within the system, and give certain players a perceived hedge against rate movements, while they all took the credit risk of TBTF's.  There is no net reduction of rate risk to the system.  The only way for the entire system to reduce the rate risk is for the system to pay down debt, which certainly ain't a good thing for the financials. 

 

All this rant is just to say that if TBTF's all just behave like a bigger version of US Bank, then it's one thing, but they don't, and therefore it's another thing all together.

 

This thread is pretty old but...

 

Why aren't the derivative markets regulated? If the big banks stand to lose potentially trillions (and presumably be wiped out) on defualts it seems that they should be regulated quite heavily. I can't remember off the top of my head but in "This Time is Different" by Reinhardt and Rogoff, on average a country defaults every, say, 15 years. From there if a country goes under, then it costs the banks hugely. Maybe they can afford it, maybe not. But what if there is another world war and a number of large countries defualt? Then how many of the TBTF banks go belly up? And how many at the same time? That has the potential to freeze the credit markets doesn't it?

 

If Buffett thinks they are finaicial weapons of mass destruction, it seems pretty likely that that is true. What do you guys think?

[watsa_is_a_randian_hero]

Ericopoly - I like most of your posts, but not this one.  By your logic here we should just have 1 bank and no competition.  The bank wouldn't need to "waste" money on advertising then, and the FDIC would have no purpose! 

 

This is the flawed logic of Marx. 

 

The TBTF banks suffer from an institutional imperative.  The regulatory barriers to entry combined with the competitive advantage of marketing yourself as TBTF creates a void of competition and lines the pockets of management.  Personally I think a better solution to government backstops on TBTF would be to have assessable shares, or boardmember liability, or perhaps just a separate share class that is assessable, or private deposit insurance (so risky banks are penalized with higher premiums). 

 

I would personally not invest TBTF banks in this environment.  The administration has been extracting "justice" in the form of headline settlements weekly.  What sense does it make to punish shareholders (who have already been punished with losses) with penalties for management's misdoings?  What sense does it make to own shares in most of these banks at this price level?  Many midsize banks offer great value...I've mentioned FCBN as one of my largest holdings before.  This is an $8 billion family-run very conservative bank with a history of 15%+ average returns on TBV trading at a cheaper TBV multiple (0.8x) than all of the TBTF banks.  Albeit, it is somewhat illiquid, but its larger sister ($20-billion) FCNCA trades at 1.1x has more liquidity and has the same board and controlling shareholders and a similar track record. 

[Guest wellmont]

i don't think it's about size. be as big as you want but don't do anything so risky that you need to be bailed out by taxpayers. make the CEO and board suffer grave financial consequences if it needs a bailout. limit what they can do to destroy themselves. the more limits on what they can do the better.  turn them into financial utilities that pay big dividends.

[DoddDisciple]

What does everyone think about bringing back the partnership model where owners are personally liable? This is how a lot of these large investment and banking houses use to be set up.

[beerbaron]

What does everyone think about bringing back the partnership model where owners are personally liable? This is how a lot of these large investment and banking houses use to be set up.

 

Too late, it's impossible to go back now. Also, banks need access to the capital market as it add to their long term survival rate.

 

BeerBaron