Banks' Talent: Being Big

Earlier today, one of my colleagues here at the Atlantic made a point about something he believes we should learn from the financial crisis. He thinks the free market does not necessarily ensure that the greatest rewards go to the most talented. He made the point in reference to all the talk of high frequency trading, saying that talent had little to do with it, but instead better technology helped reap significant rewards in that case. I think that's partially true, though free marketers might argue that the talent of programmers writing the computer code for trading and the innovation of thinking to engage in high frequency trading in the first place might be responsible for those profits. Still, I agree with his general idea, but would take it a step further: the reason talent sometimes has nothing to do with profit results from barriers to entry.

Let's look more at the case of high frequency trading. Sure, that's a technological innovation. But it's an innovation that only large firms with significant technological prowess can enjoy. Smaller trading firms, for example, probably don't have the infrastructure to engage in the practice. As a result, they don't see as much profit. That additional profit keeps the big firms growing faster than the smaller firms.

Barriers to entry also played a part in the mortgage market's problems. In a recent piece for The Atlantic's Business Channel, Mike Konczal argues that community banks should support a Consumer Financial Protection Agency. Although I have mixed feelings about his general thesis, I think he's right that big banks and mortgage companies were able to fool many unsuspecting borrowers into believing that they would be better off with a wacky mortgage product. He quotes Richard Serlin who says:

There may be great opportunities to profit by deceiving consumers, and large scale advertising and other marketing can be very effective at that. Big companies are much more capable of doing this than small ones because of the great economies of scale involved.

The rating agencies are also largely blamed for making huge errors in rating mortgage-backed securities. Again, barriers to entry prevented new rating agencies from offering an alternative viewpoint. This time, those barriers were mostly government imposed.

Even the banks who had underwritten the most mortgage-backed securities were able to do so through some barriers to entry. Generally, they underwrote MBS with pools of their own mortgages, first making profit on the mortgages and then mitigating the risk to investors, but not before taking another piece of the pie through investment banking fees. Boutique banks didn't have a shot at that underwriting. Moreover, even mortgage companies like Countrywide or Ameriquest generally rewarded the big banks who provided them with the most unsecured loans or credit lines with the investment banking fees from their deals. Again, small banks just can't compete with their big balance sheets.

I'm not sure the solution. I'm not necessarily calling for the breakup of all big banks. But I am worried that one of the implications of the crisis is that all those banks that are characterized as being "too big to fail" are being further protected by the government as a result. That status created through government's will to always rescue them up will provide cheaper funding than smaller banks can obtain. This provides yet another competitive advantage and further strengthens the barrier to competition that smaller banks face.

It's got to be about more than just talent. After all, if it were left to talent, most of those banks would have gone bankrupt. They all incurred billions of dollars in mortgage-security related losses and were all on the brink of collapse. If their investment managers, bankers and traders were so smart, how did that happen? I don't doubt that these banks have some exceptional talent within their walls, but they also have serious competitive advantages that create huge barriers to entry and allow them to continue to profit wildly.

Remember, for free markets to work effectively barriers to entry need to be minimized.
The $700 billion question, I think, is how to break down those barriers big banks have created without disturbing the financial markets.