June 30, 2010

Put Your Money in Smaller Banks: A Guest Post

Last week, I confessed that my BP boycott was probably shortsighted, but didn't know what else to do.

This prompted some interesting Facebook conversations about what else we should be boycotting. Which leads us to a guest post today from my friend, Bry Willis. I offer a quick counter-point at the end.

Put Your Money in Smaller Banks
A guest post by Bry Willis

"When promoting small banks, we are more importantly advocating local banking. Local banking keeps money closer to the community, so the money saved there is more likely to be invested nearby. It's also better for small businesses, because proportionally, smaller banks lend more to small businesses than larger banks. When a local bank writes a mortgage, they also have a greater interest in scrutinizing the creditworthiness of the borrower. The largest banks tend to repackage these mortgages, passing the risk on to another party, so they have little vested interest in the quality of the loan or the community where the loan originated. Small banks were not responsible for the recent financial meltdown and failure of the derivatives market. They were also not creating these instruments and putting depositor money at risk. 

Credit unions are another local alternative. They are similar to banks, but they are owned by their depositors. People with common interests pool their funds and earn interest on their deposits by providing loans to one another—think of the Bailey Building & Loan in the holiday classic film, "It’s a Wonderful Life."

Also, despite what you may assume, bigger banks statistically have higher fees and worse interest rates than small banks.

Smaller banks are also more likely to provide you personal service—to treat you like a human instead of a number. You are more likely to speak with a human instead of winding through a labyrinth of telephone service automation: “Press 5 to talk to someone. We care about your call; we just don’t care enough to hire someone to speak with you in the next 20 minutes…”

As the adage goes, “Think globally. Act locally.” These banks you should avoid like the plague: Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley."


Thanks Bry! Although, I have a follow-up question on your logic. You have convinced me that local banks are better in my self-interest, from a sheer capitalist point of view. If this changes in the future, and I can get better interest rates and lower fees from a large bank with better efficiencies, should I switch?


Arcane Rest said...

at what point should I no longer support a local bank? is it when the bank reaches 3 branches, 10, 15 branches, maybe 25?

did chase start as a local bank?
when did they turn bad?

just wanting to know when I should institute my boycott on the local bank.

MicroGlyphics said...

Due to a 4,096 character limit, I need to break my response into two posts.

It’s not so much a difference between big and small as it is a difference to mega banks, the ones that are too big to fail. I didn’t want my initial post to be overly technical or arcane. (Pun not initially intended.) As I state, the 6 banks at the bottom of the original post are considered to be too big to fail, TBTF. These banks commingle commercial funds with investment funds. Smaller banks don’t usually have a tightly integrated investment banking arm. One reason the Glass-Steagall Act was introduced in 1933 during the depression as a reaction to the stock market crash of 1929 in order to separate commercial and investment banking functions.

On one hand, commercial banks accept deposits and makes loans. They make profits on the difference. When people put money into a commercial bank, they presume that they will be able to withdraw at least the same amount as they deposited. FDIC was created to ensure proceeds (these days up to $250,000) will be available, so to discourage bank runs.

On the other hand, investment banks make investments and earn profits on assets under management and fees for creating and marketing investment vehicles including securities and derivatives. These banks are designed for investors—people who understand that their principle investments may not retain value but who accept this risk for the probability of a positive—if not substantial—return. There is no explicit government guarantee to ensure these funds will be available when the investor wants to withdraw them.

Glass-Steagall was repealed in 1999 by the Gramm-Leach-Bliley Act. Effectively, this brought down the wall separating commercial and investment banking functions, allowing a single business entity to perform both. This led to having banks grow to a size TBTF.

The problem with the TBTF banks is that they have access to guaranteed funds they can nonetheless invest. The guarantee creates a moral hazard because the bank knows the government will make good up to the insured limit. Moral hazard occurs when an entity subject to a risk does not bear the full burden of the risk. Besides knowing explicitly that the FDIC will rescue these banks taking extensive risk and exercising poor fiduciary responsibility, these banks know, too, being TBTF, that they will be implicitly protected as well. This results in not caring to analyse the full risk involved in a transaction, but all of this comes at large social costs. The US government ended up making over $13 trillion to ensure that the financial crisis of 2007 didn’t end up worse than it already was. The corporate media focuses on the $700 billion TARP programme, but that was a pittance.

[In order to keep the economy afloat (read: house of cards), the Federal Reserve had to extend almost interest-free credit to these large banks (and even non-banks like AIG). Firms like Morgan Stanley and Goldman Sachs invested this free money, the result being huge profits for the financial sector. Of course, there was no risk, even if they lost it all again, they knew that the US would come to the rescue again. Can anyone say regulatory capture? But I digress...]

It turns out that it is more likely that your bank will be bought out by a mega-bank than become one due to the exertion of noncompetitive oligopolistic powers over the marketplace. Je m’accuse, mais I still use JP Morgan Chase for some banking services. The relationship started in the 90s at Coast Federal. During consolidation, Coast was swallowed by (the now defunct) Washington Mutual (WaMu), which was in turn consumed by Chase. I have since severed most ties and have transferred my business to a credit union.

MicroGlyphics said...

Federal Reserve Bank of Dallas president, Richard W. Fisher, captured this best in a speech:

"The banking industry has become much more concentrated as it has grown in recent years. In 1995, the assets of the six largest banks were equivalent to 17 percent of GDP; now they amount to 63 percent of GDP. Meanwhile, the share of all banking industry assets held by the top 10 banks rose to 58 percent last year, from 44 percent in 2000 and 24 percent in 1990."

With this degree of market power, consumers become the losers.

Finally, addressing the issue of efficiency, economics has a concept called economies of scale. This concept posits that (for a variety of reasons) larger firms can gain efficiencies over smaller firms. However, there is also a concept called diseconomies of scale, which is where these efficiencies break down. I’ll argue that these TBTF firms have reached this scale. This oligopolistic power allows them to make up for some of this inefficiency by commanding excess profits.

I could go on (and on and on), but I hope I addressed the questions raised.

[Please excuse the deletions. I received errors saying that the post was too long, but by the time I realised that they were posting anyway, it was too late.]

Arcane Rest said...

So this isn't necessarily the size of the bank that will dictate the reason for not placing my money there but the business practices that are unsafe or considerably risky?

So I should just know, who I make my bed with when I do business to ensure that my money does not encourage horrendous practice?

Ben R said...

Good idea. Probably don't want to stay with the big guys who completely failed.