Juan Laborda – Spain Promotes Banks that are too Big and too Strategic to fail

The Spanish banks were generously bailed out following the Global Financial Crisis. Why not do it again?

Juan Laborda teaches Financial Economics at the University of Carlos III and Money and Banking, Syracuse University (Madrid)

Originally published in Spanish at vozpopuli (en Español)

Translated and edited by BRAVE NEW EUROPE

Sede del Banco de España
I can’t help but be amazed at how many people in our beloved Spain take certain clichés for granted, without even discussing whether what lies behind them is true. This is happening in the face of the wave of bank mergers, and the widespread consensus that there is no alternative. I reject this claim. It is completely false that there is no alternative, and even worse, with what is being done the fragility of our banking system is increasing exponentially. What is surprising is the position of the regulator, our central bank, the Banco de España, which either does not comprehend the danger or is simply looking the other way. I suggest that our regulator study the literature that its English counterpart has deployed under the leadership of Andy Haldane, chief economist and executive director of Monetary Analysis and Statistics at the Bank of England. Haldane shows in some of his work the striking similarities between epidemics such as SARS or Covid 19 with financial and/or banking crises. I highly recommend the book by the epidemiologist and mathematician Adam Kucharski, “The Rules of Contagion: How Epidemics Arise, Spread and Disappear” and its references to the analogies between contagion in the banking and/or financial systems and epidemics, outlining his conversations with Andy Haldane.

Andy Haldane, as early as 2005, wrote a note where, from his analysis, the network structure of the international financial system made it vulnerable to super-systemic risk, as was the case in 2008. In that note Haldane stressed that this network structure could make it resistant to minor shocks, but it made it tremendously vulnerable to total collapse if subjected to too much pressure. The basic idea was that all integration reduces the probability of a minor crisis, but increases the probability of a major crisis. That is what our banking system is currently doing without anyone raising their voice. I am raising it, and loudly. It is an outrage that we will end up paying for dearly.

Haldane’s simple idea was confirmed in a 2006 study by researchers from the New York Federal Reserve, “The Topology of Interbank Payments Flows”, which analysed the trillions of dollars in transfers that took place between thousands of US banks during a normal day, 75% of the payments involved a very small number of banks. The variability in linkages was not the problem, but how these large banks fit into the rest of the network.

The banking network is, from the epidemic theory, dissociative

In epidemic theory, such as in the case of Covid-19, the dynamics of infections will depend on whether the network of contacts is associative or dissociative. In an associative network, densely-connected individuals are mainly linked to other densely people. The result is an outbreak that spreads very quickly through clusters of high-risk individuals, but has difficulty reaching the other, less connected parts of the network. In contrast, in a dissociative network, high-risk individuals are mostly connected to low-risk individuals. This causes the infection to spread slowly at first, but eventually to end up in a larger epidemic. The banking network is deeply dissociative. Warren Buffett spoke of “the overwhelming web of mutual dependence between the big banks”. Moreover, bank mergers, under the current network structure, encourage bad behaviour, and the mega-banks that arise take on unnecessary risks on the grounds that the government will come to their aid if problems arise (Too big to fail).

Another idea widely shared in the financial and banking world is that banks can diversify to reduce their overall risk. The problem is that they usually all choose to invest in the same types of assets and the same ideas, so the opposite is true – diversification profoundly destabilises the whole network. Andy Haldane and epidemiologist Robert May in the article “The birds and the bees, and the big Banks” point out that historically the biggest banks have held less capital than the smaller ones in the belief that they had more diversified investments, so they took less risk. The reality, as we have detailed, shows quite the opposite. That is why it is striking how, in the face of the bank mergers that are being announced, some are reducing capital requirements. This situation is further complicated by the fact that, unlike biological contagion, in the banking system it is not necessary to have direct exposure in order to become ill, an indirect effect of fear and panic is sufficient. The bank mergers that are unfolding in our country no longer only create the moral dilemma of creating banks that are too big to fail, but are also too strategic to fail. It is therefore necessary for those banks that are important to the network to retain more capital to reduce their susceptibility to infection.

The structure of the banking network must be changed, by chopping up banks not merging them

Andy Haldane in his talks with Adam Kucharsky points out that action was needed to change the structure of the banking network, but the bankers immediately began to protest because they interpreted this as an intrusive intervention in their business model. However, in the UK, unlike in our country, they did change the network structure to reduce possible future contagion. According to the UK Financial Services Act, drawn up on the basis of the 2011 Vickers Report, by 2019 institutions were required to establish a ring of protection around their commercial business (current and savings accounts, mortgages, loans to individuals and companies…), which would have its own legal status and would be managed independently from the bank’s other more risky activities, such as investments. Where appropriate, the Vickers report, as also suggested by the Volcker report for the United States, raised the need to impose limits on the concentration of deposits, loans or other banking indicators, in short on the size of banks. In addition to restricting risky activities, the aim was to limit the size of banks.

In short, while in the United Kingdom they have tried to eliminate hidden loops from the network, in “Spain”, by means of bank mergers, the exact opposite is being rewarded. On the one hand, banks that are too big to fail, and too strategic to fall, are being promoted. On the other hand, they are being encouraged to continue to keep a huge amount of toxic assets hidden on their balance sheets. The ultimate reason for mergers is that when toxic assets spiral out of control , these banks approach insolvency and, look for someone to merge with to start the whole process anew.

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