Do We Need Big Banks?

The financial crisis has brought attention to the costs and benefits of large banks. A new working paper by Asli Demirgüç-Kunt and Harry Huizinga finds that banks large in absolute size—measured by assets – tend to be more profitable, but carry higher risk. But banks large in systemic size — measured by the ratio to the economy – tend to be less profitable, but still carry high risk. In addition, despite too-big-to-fail subsidies, systemically-large banks are subject to greater market discipline, suggesting that they are often too big to save. Indeed, a bank’s rate of return on assets tends to decline with systemic size, partly because its interest cost tends to rise with its systemic size. Market discipline, through higher funding costs, should keep systemic size in check. But clearly, it hasn’t prevented the emergence of such banks in the first place. This may be because inadequate corporate governance structures at banks have enabled managers to pursue high-growth strategies at the expense of shareholders. For that reason, the authors say greater government intervention appears to be needed. The research is based on a large sample of banks in 80 countries from 1991 to 2009.