Bankers Discover That Small is Beautiful Again

Diseconomies of scale and scope. If that bit of economists’ jargon is unfamiliar to you, you are not alone. It means that some companies are so big that they are less efficient than smaller rivals, and so diversified that they are beyond the ability of ordinary mortals to manage. This phrase hasn’t been much used in past decades. After all, bigger seemed better, and the products of MBA programmes thought themselves capable of managing such a wide variety of businesses that knowledge of the nuts and bolts of any one of them seemed a waste of space in the executive brain. Surely, these companies were benefiting from economies of scale and scope – costs that decline the bigger and more diversified they get.

Well, not surely. We have learnt from this crisis that there is a point at which bigger is worse, and diversification can increase rather than decrease risk.

AIG was a well managed and profitable insurance company before it decided to become a diversified financial operation, with bright, young “quants” taking on risks the company’s executives did not understand and therefore could not manage. Several of the banks now forced to go hat-in-hand to governments for bailouts were nice, profitable institutions when they stuck to trading, taking deposits and making loans to borrowers they knew personally or had reason to believe could actually repay the money.

As these firms became grander, and their managers more confident of their ability to run these behemoths, they became too big and too interconnected to be allowed to fail, at least in the view of politicians who see the financial system as a house of cards, in which any one big player can bring down all the others, and the real economy as well. Bankers played on these fears as they inserted their snouts in the bailout trough.

What they hadn’t reckoned with was the quite sensible public reaction: if the effect of the failure of these firms is not confined to their shareholders and employees, but can bring down the economy, surely they are like electricity companies and other utilities, and should be regulated as such – told to lend more to some applicants, less to others; not to dare to seize assets of borrowers (read, voters) in default; not to pay staff more than a risk-averse congressman in a safe seat deems proper.

Consider the case of Lehman Brothers. Hank Paulson, former Treasury secretary, was upset that his bailout of Bear Stearns was being said to have unleashed a dreaded case of moral hazard on the private sector, so he decided that Lehman should be allowed to go under.

The result was a disaster for the so-called counter-parties. Institutions that traded with Lehman had $582 billion of their assets frozen while the administrators sorted out the mess. Not everyone is a loser: the lawyers and accountants sorting out the European end of the company’s affairs have run up bills of more than $100m in six months, and the meters continue to tick at rates of £620 an hour for senior accountants and higher still for top lawyers.

We will never know if the counter-parties and other bystanders to the Lehman crash would have taken steps to minimise their losses if Paulson had not bailed out Bear Sterns, creating the moral hazard his critics feared. But we do know a few things.

The first is that if a big financial institution were to go down, there is enough risk of collateral damage to prompt government to intervene lest credit dries up and innocent bystanders pay a huge price in lost incomes, jobs and homes. The second is best put by Carnegie Mellon professor Allan Meltzer, America’s leading student of the banking system: “If a bank is too big to fail, it is too big.” The third is that bank managements do not understand the risks created for them by the modellers and other practitioners of arts invented long after many senior bankers began to concentrate on climbing the corporate ladder rather than brushing up on higher maths.

All of which has prompted my government and yours to protect their investments in the banks they have bailed out, and to keep pitchfork-wielding mobs at bay by placing limits on executive compensation, most particularly bonuses and perks such as private jets and meetings in exotic locations.

Such government actions have had unintended consequences that are damaging to the public interest, most notable being the higher death toll from car accidents as vehicles have become smaller in the interests of fuel economy. But the unintended consequence of attempts to deprive financial entrepreneurs of the incomes to which they feel their ingenuity and risk-taking entitle them is likely to prove in the public interest. It just might lead to a restructuring of the financial-services industries that results in more innovation, more competition, and less systemic risk.

Talented men and women are leaving the big banks in increasing numbers. Some of the best and brightest are joining boutique investment houses, others are starting their own firms. In London, Peter Stott, a partner at Greenhill & Co, tells me his independent investment-banking firm has “seized a once-in-a-lifetime opportunity” and hired some 20 top bankers from larger, struggling investment banks in the past 15 months, and that Lazard, Rothschild, and start-ups such as Centerview and Moelis “have been aggressively adding good senior people”.

No more time wasted in committee meetings, no more worrying about the reaction of excitable congressmen to expenses incurred entertaining clients, no more being pilloried for claiming a well-deserved bonus. The result is that risk-taking is spread across more institutions, the stranglehold of the big banks on access to capital is reduced, and compensation is directly linked to success.

Happy days may not quite be here again, to borrow from Franklin Roosevelt’s theme song, but when they come we might just have a financial system populated by at least some firms that are neither too big nor too interconnected to fail.