This article is from the July/August 2010 issue of Dollars & Sense: Real World Economics, available at

issue 289 cover

This article is from the July/August 2010 issue of Dollars & Sense magazine.


Not Too Big Enough

How the “too-big-to-fail” banks got that way, and why the current banking reform won’t solve the problem.

By Rob Larson

The government bailout of America’s biggest banks set off a tornado of public anger and confusion. With a price tag in the trillions of dollars, rescuing the biggest American banks has left the public resentful over the bailout of banks considered “too big to fail.” But two years later, the Senate has rejected a proposal to break up today’s “megabanks” into smaller institutions, claiming that tougher reserve requirements and higher insurance premiums will prevent future large-scale bank failures.

Dealing with the collapse of these “systemically important banks” is a difficult policy issue, but the less-discussed issue is how the banking industry got to this point. If the collapse of just one of our $100 billion megabanks, Lehman Brothers, was enough to touch off an intense contraction in the supply of essential credit, we need to know how some banks became “too big to fail” in the first place. The answer lies in certain incentives for bank growth, which after the loosening of crucial industry regulations drove the enormous waves of bank mergers in the last thirty years.

Geographical Growth and Economies of Scale

Before the 1980s, American commercial banking was a small-scale affair. State-chartered banks were prohibited by state laws from running branches outside their home state, or sometimes even outside their home county. Nationally chartered banks were likewise limited, and federal law allowed interstate acquisitions only if a state legislature specifically decided to permit out-of-state banks to purchase local branches. No states allowed such acquisition until 1975, when Maine and other states began passing legislation allowing at least some interstate banking. The trend was capped in 1994 by the Riegle-Neal Act, which removed the remaining restrictions on interstate branching and allowed direct cross-state banking mergers.

How Did They Get So Big?

A Too-Big-to-Fail Timeline

By Jill Mazzetta

1975: Maine becomes the first state to open its borders to out-of-state banks. Other states quickly follow suit.

1977: Lehman Brothers merges with Kuhn, Loeb & Co.; becomes fourth-largest investment bank in the United States.*

1984: Lehman Brothers acquired by Shearson/American Express, a brokerage company, for $360 million.

1986: Wells Fargo acquires Crocker National Bank for about $1.1 billion; becomes the tenth largest commercial bank in the United States; sets record for largest bank acquisition in history.**

1992: Bank of America acquires Security Pacific Corporation; takes title of largest bank acquisition in U.S. history.

1994: Riegle-Neal Act passed. Allows national banks to set up branches anywhere in the United States, regardless of whether they own a subsidiary in any state they receive deposits from.

Bank of America acquires Continental Illinois National Bank and Trust Co.; becomes the largest U.S. bank in terms of deposits.

1995: Wells Fargo acquires First Interstate Bancorp for $11.3 billion in hostile takeover; becomes ninth largest bank.

1996: Chemical Bank acquires Chase Manhattan Corp. and takes its name.

1997: NationsBank Corp. acquires Bank of America for $64.8 billion; sets new record for the largest bank acquisition in history.

1998: First Union acquires CoreStates Financial Corp. for $17 billion.

Long-Term Capital Management (LTCM) runs out of funds. Federal Reserve Bank of New York organizes a $3.6 billion bailout by several major creditors, including Goldman Sachs, JP Morgan, and Lehman Brothers. Participating banks get a 90% share in LTCM.

Citicorp merges with Travelers Group to form Citigroup for $70 billion; becomes world’s largest financial services organization.

Wells Fargo merges with Norwest for $31.7 billion.

1999: Gramm-Leach-Bliley Act passed. Repeals part of Glass-Steagall Act of 1933, allowing commercial banks, insurance companies, investment banks, and securities firms to merge with each other.***

2000: Chase Manhattan merges with J.P. Morgan & Co. to form JP Morgan Chase.

2001: WaMu acquires PNC Mortgage Co. and Fleet Mortgage Corp.

Lehman Brothers acquires Cowen & Co.

2003: Lehman Brothers acquires Crossroads Group and Neuberger Berman. Faces SEC litigation; pays $80 billion settlement; forced to restructure.

Wachovia acquires Metropolitan West Securities; adds over $50 billion in securities to its portfolio.

2004: Bank of America acquires FleetBoston Financial for $47 billion.

JP Morgan Chase merges with BankOne Corp.

Wachovia acquires SouthTrust Corp. for $14.3 billion; becomes the largest bank in southeastern United States.

2005: Bank of America acquires MBNA (Maryland Bank, National Association) for $35 billion.

2006: Wachovia acquires Golden West Financial for about $25.5 billion.

2007: April: Citigroup suffers from subprime mortgage crisis; eliminates 17,000 jobs.

August: Lehman Brothers closes BNC Mortgage, its subprime lending firm; leads to 1,200 job cuts.

Bank of America acquires Countrywide Financial for $4.1 billion; becomes the country’s leading mortgage servicer, cornering about 25% of the market. Countrywide becomes Bank of America Home Loans.

September: Bank of America acquires LaSalle Bank for $21 billion.

December: WaMu reorganizes loan division, closing offices and laying off 2,600 staff.

2008: March: JP Morgan Chase acquires Bear Stearns for $236 million.

April: WaMu closes offices and lays off 3,000 due to subprime mortgage crisis; receives $7 billion infusion from outside investors.

September: Massive bank run on WaMu; customers withdraw $16.7 billion over 10 days.

Lehman Brothers files for Chapter 11; is the largest bankruptcy in U.S. history.

Bank of America acquires Merrill Lynch for about $50 billion; becomes the world’s largest financial services company.

WaMu seized by the Office of Thrift Supervision, handed over to FDIC; FDIC sells WaMu’s assets, debts, and deposits to JP Morgan Chase for $1.9 billion.

Wachovia declared “systematically important,” i.e. too big to fail, by the FDIC; FDIC plans to auction off its assets.

October: Emergency Economic Stabilization Act (“the bailout”) passes. Allows U.S. Treasury to spend $700 billion purchasing troubled assets (e.g. subprime mortgages) and injecting capital directly into banks.

Goldman Sachs receives $10 billion in TARP funds.

November: U.S. government agrees to back $306 billion in Citigroup’s loans and invest another $20 billion directly into the company.

December: Wachovia acquired by Wells Fargo for $15.1 billion to avoid failure.

2009: January: Bank of America reports massive losses from Merrill Lynch; receives $20 billion in emergency TARP bailout funds to stay solvent, in addition to an initial TARP investment of $25 billion from fall 2008.

March: New York Times article claims Bank of America received an additional $5.2 billion in government funds, channeled through AIG.

June: Goldman Sachs repays TARP investment with interest.

August: Bank of America agrees to pay $33 million fine to SEC for not disclosing bonus payments totaling $5.8 million to top Merrill Lynch employees.

December: Bank of America announces it will repay the $45 billion it received from TARP and exit the program.

*Investment bank size measured by revenue or fee income and by market share as opposed to commercial banks, which are measured by deposits and market share. **Bank acquisitions are measured and ranked based on price paid by the acquiring company. ***Major turning point in deregulation: to reflect the fact that banks can now offer a variety of financial services, bank holding companies begin ranking themselves by asset size and market capitalization, not deposit size. These multi-service institutions are no longer technically classified as banks, but as “financial service companies.”

Selected sources: “The 1970s,”, accessed May 7, 2010; “Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994,”, accessed May 7, 2010; Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management, 2000; “Gramm-Leach-Bliley Summary of Provisions,”, accessed May 7, 2010; “Red flags in Bear Stearns’ collapse,” USA Today, March 19, 2008; Julie Creswell and Ben White, “Wall Street, R.I.P.—End of an Era, Even at Goldman,” New York Times, September 27, 2008; “Emergency Economic Stablization Act of 2008,”, accessed May 7, 2010; “Chronology of a Meltdown,” Dollars & Sense, September/October 2008; “U.S. pushed Bank of America to complete Merrill buy,” Reuters UK, February 5, 2009.

Jill Mazzetta is a recent graduate of Emerson College and a Dollars & Sense intern.

This geographic deregulation allowed commercial banks to make extensive acquisitions, in-state and out. When Wells Fargo acquired another large California bank, Crocker National, in 1986 it was the largest bank merger in U.S. history. Since “the regulatory light was green,” a single banking company could now operate across the uniquely large U.S. market, opening up enormous new opportunities for economies of scale in the banking industry.

Economies of scale are savings that companies enjoy when they grow and produce more output. The situation is similar to a cook preparing a batch of cookies for a Christmas party and then preparing a batch for New Year’s while all the ingredients and materials are already out. Producing more output (cookies) in one afternoon is more efficient than taking everything out again later to make the New Year’s batch separately. In other words, there’s less effort per cookie if you make them all at once. In enterprise, this corresponds to spreading the large costs of startup investment over more and more output, and is often thought of as lower per-unit costs as the level of production increases. Economies of scale, when present in an industry, create a strong incentive for firms to grow larger, since profitability will improve. But they also give larger, established firms a valuable cost advantage over new competitors, which can put the brakes on competition.

Once unleashed by the policy changes, these economies of scale played a major role in the industry’s seemingly endless merger activity. “In order to compete, you need scale,” said a VP for Chemical Bank when buying a smaller bank in 1994. Of course, in 1996 Chemical would itself merge with Chase Manhattan Bank.

Spreading big investment costs over more output is the main source of generic economies of scale, and in banking, the large initial investments are in sophisticated computer systems. The cost of investing in new computer hardware and systems is now recognized as a major investment obstacle for new banks, but once they are installed by banks large enough to afford them, they are highly profitable. The Financial Times describes how “the development of bulk computer processing and of electronic data transmission...has allowed banks to move their back office operations away from individual branches to large remote centers. This has helped to bring real economies of scale to banking, an industry which traditionally has seen dis-economies set in at a very modest scale.”

Economies of scale are common in manufacturing, and in the wake of deregulation the banking industry was also able to exploit a number of them. Besides spreading out the cost of computer systems, economies of scale may be present in office consolidation, in the funding mix used by banks, and in advertising. Economies of scale can produce savings that companies benefit from as they grow larger and produce more output. While common in many industries, in banking and finance these economies drove bank growth after industry deregulation in the 1980s and 1990s. Some of the major scale economies in banking are:

  • Spreading investment over more output. With the growth in importance of large-scale computing power and sophisticated systems management, the costs of setting up a modern banking system are very large. However, as a firm grows it can “spread out” the cost of that initial investment over more product, so that its cost per unit decreases as more output is produced.
  • Consolidation of functions. The modern workforce is no stranger to the mass firings of “redundant” staff after mergers and acquisitions. If one firm’s payroll staff and computer systems can handle twice the employees with little additional expense, an acquired bank may see its payroll department harvest pink slips while the firm’s profitability improves. When Citicorp merged with the insurance giant Travelers Group in 1998, the resulting corporation laid off over 10,000 workers—representing 6% of the combined company’s total workforce and over $500 million in reduced costs for Citigroup. This practice can be especially lucrative in a country like the United States, with a fairly unregulated labor market where firms are quite free to fire. Despite the economic peril inflicted on workers and their families, this consolidation is key to increasing company efficiency post-merger. Beyond back-office functions, core profit operations may also benefit from consolidation. When Bank of America combined its managed mutual funds into a single fund, it experienced lower total costs, thanks to trimming overhead from audit and prospectus mailing expenses. Consolidating office departments in this fashion can yield savings of 40% of the cost base of the acquired bank.
  • Funding mix. The “funding mix” used by banks refers to where banks get the capital they then package into loans. Smaller institutions, having only limited deposits from savers, must “purchase funds” by borrowing from other institutions. This increases the funding cost of loans for banks, but larger banks will naturally have access to larger pools of deposits from which to arrange loans. This funding cost advantage for larger banks relative to smaller ones represents another economy of scale.
  • Advertising. The nature of advertising requires a certain scale of operation to be viable. Advertising can reach large numbers of potential customers, but if a firm is small or local, many of those customers will be too far afield to act on the marketing. Large firm size, and especially geographic reach, can make the returns on ad time worth the investment.

Industry-to-Industry Growth

BusinessWeek’s analysis is that the banking industry “has produced large competitors that can take advantage of economies of regulatory barriers to interstate banking fell,” although not until the banks could “digest their purchases.” The 1990s saw hundreds of bank purchases annually and hundreds of billions in acquired assets.

But an additional major turn for the industry came with the Gramm-Leach-Bliley Act of 1999 (GLB), which further loosened restrictions on bank growth, this time not geographically but industry-to-industry. After earlier moves in this direction by the Federal Reserve, GLB allowed for the free combination of commercial banking, insurance, and the riskier field of investment banking. These had been separated by law for decades, on the grounds that the availability of commercial credit was too important to the overall economy to be tied to the volatile world of investment banking.

GLB allowed firms to grow further, through banks merging with insurers or investment banks. The world of commercial credit was widened, and financial mergers this time exploited economies of scope—where production of multiple products jointly is cheaper than producing them individually. As commercial banks, investment banks, and insurers have expanded into each others’ fields in the wake of GLB, their different lines of business can benefit from single expenses—for example, banks perform research on loan recipients that can also be used to underwrite bond issues. Scope economies such as these allow the larger banks to both run a greater profit on a per-service basis and attract more business. Thanks to the convenience of “one stop shopping,” Citigroup now does more business with big corporations, like IT giant Unisys, than its component firms did pre-merger.

Exploiting economies of scope to diversify product lines in this fashion can also help a firm by reducing its dependence on any one line of business. Bank of America weathered the stock market downturn of 2001 in part because its corporate-debt-underwriting business was booming. Smaller, more specialized banks can become “one-trick ponies” as the Wall Street Journal put it—outdone by larger competitors with low-cost diversification thanks to scope economies.

These economies of scope are parallel to the scale economies, since both required deregulatory policy changes to be unleashed. Traditionally, banking wasn’t seen as an industry with the strong economies of scale seen in, say, manufacturing. But the deregulation and computerization of the industry have allowed these firms to realize returns to greater scale and wider scope, and this has been a main driver of the endless acquisitions in the industry in recent decades.

Market Power

The enormous proportions that the banking institutions have taken on following deregulation have meant serious consequences for market performance. A number of banks have reached sufficient size to exercise market power—the ability of firms to influence prices and to engage in anticompetitive behavior. The market power of our enormous banks allows them to take positions as price leaders in local markets, where large firms use their dominance to elevate prices (i.e., increase fees and rates on loans, and decrease interest rates on deposits). Large firms can do this because smaller firms may perceive that lowering their prices to take market share could be met by very drastic reductions in prices from the larger firm in retaliation. Large firms, having deeper pockets, may be able to withstand longer periods of operating at a loss than the smaller firms.

Small banks are likely to perceive that the colossal size and resources of the megabanks make them unprofitable to cross—better to follow along and charge roughly what the dominant, price-leading firm does. Empirical research by Federal Reserve Board senior economist Steven Pilloff supported this analysis, finding that the arrival of very large banks in local markets tended to increase bank profitability for reasons of price leadership, due to the larger banks’ economies of scale and scope, financial muscle, and diversification.

Examples of the use of banking industry market power are easy to find. Several bills now circulating Congress deal with the fees retail businesses pay to the banks and the credit-card companies. When consumers make purchases with credit cards, two cents of each dollar goes not to the retailer but to the credit card companies that run the payment network and the banks which supply the credit for cards branded Visa and MasterCard. These “interchange fees” bring in over $35 billion in profit in the United States alone, and they reflect the strong market power of the banks and credit card companies over the various big and small retailers. The 2% charge comes to about $31,000 for a typical convenience store, just below the average per-store yearly profit of $36,000; this has driven a coalition of retailers to press for congressional action.

Visa has about 50% of the debit-credit card market, and MasterCard has 25%, which grants them profound market power and strong bargaining positions. Federal Reserve Bank of Kansas City economists found the United States “maintains the highest interchange fees in the world, yet its costs should be among the lowest, given economies of scale and declining cost trends.” The Wall Street Journal’s description was that “these fees...have also been paradoxically tending upward in recent years when the industry’s costs due to technology and economies of scale have been falling.” Of course, there’s only a paradox if market power is omitted from the picture. The dominant size and scale economies of the banks and the credit-card oligopoly allow for high prices to be sustained—bank muscle in action against a less powerful sector of the economy. The political action favored by the retailers includes proposals for committees to enact price ceilings or (interestingly) collective bargaining by the retailers. As is often the case, the political process is the reflection of the different levels and positions of power of various corporate institutions, and the maneuvering of their organizations.

Market power brings with it a number of other advantages. A powerful company is likely to have a widespread presence, make frequent use of advertising, and be able to raise its profile by contributing to community organizations like sports leagues. This allows the larger banks to benefit from stronger brand identity—their scale and resources make customers more likely to trust their services. This grants a further advantage in the form of customer tolerance of higher prices due to brand loyalty.

Political Clout

Crucially, large firms with market power are free to participate meaningfully in politics—using their deep pockets to invest in electoral campaigns and congressional lobbying. The financial sector is among the highest-contributing industries in the United States, with total 2008 campaign contributions approaching half a billion dollars, according to the Center For Public Integrity. So it’s unsurprising that they receive so many favors from the state, since they fund the careers of the decision-making state personnel. This underlying reality is why influential Senator Dick Durbin said of Congress, “The banks own the place.”

Finally, banks may grow so large by exploiting scale economies and market power that they become “systemically important” to the nation’s financial system. In other words, the scale and interconnectedness of the largest banks are considered to have reached a point where an abrupt failure of one or more of them may have “systemic” effects—meaning the broader economic system will be seriously impaired. These are the banks called “too big to fail,” which were bailed out by act of Congress in the fall of 2008. Once a firm becomes so enormous that the state must prevent its collapse for the good of the economy, it has the ultimate advantage of being free to take far greater risks. Riskier investments come with higher returns and profits, but the accompanying greater risk of collapse will be less intimidating to huge banks that have an implied government insurance policy.

Some analysts have expressed doubt that such firms truly are too large to let fail, and that the banks have pulled a fast one. It might be pointed out in this connection that in the past the banks themselves have put their money where their mouths are—they have paid out of pocket to rescue financial institutions they saw as too large and connected to fail. An especially impressive episode took place in 1998, when several of Wall Street’s biggest banks and financiers agreed to billions in emergency loans to rescue Long Term Capital Management (LTCM), a high-profile hedge fund that had borrowed enormous sums of capital to make billion-dollar gambles on financial markets.

America’s biggest banks aren’t in the habit of forking over $3.5 billion of good earnings, but they had loaned heavily to LTCM and feared losing their money if the fund went under. The Federal Reserve brought the bankers together, and in the end, they paid up to bail out their colleagues; the Wall Street Journal reported that it was the Fed’s “clout, together with the self-interest of several big firms that already had leant billions of dollars to Long-Term Capital, that helped fashion the rescue.” Interestingly, the banks insisted on real equity in the firm they were pulling out of the fire, and they gained a 90% stake in the hedge fund. Comparing this to the less-valuable “preferred stock” the government settled for in its 2008 bailout package of the large banks is instructive. The banks also got a share of control in the firm they rescued, again in stark contrast to the public bailout of some of the same banks.

Even Bigger?

In fact, the financial crisis and bailout led only to further concentration of the industry. The crisis gave stronger firms an opportunity to pick up sicker ones in another “wave of consolidation,” as BusinessWeek put it. And a large part of the government intervention itself involved arranging hasty purchases of failing giants by other giants, orchestrated by the Federal Reserve. For example, the Fed helped organize the purchase of Bear Stearns by Chase in March 2008 and the purchase of Wachovia by Wells Fargo in December 2008. Even the bailout’s “capital infusions” were used for further mergers and acquisitions by several recipients. The Treasury Department was “using the bailout bill to turn the banking system into the oligopoly of giant national institutions,” as the New York Times reported.

The finance reform bill, still emerging as Congress’ response to the financial crisis, has had most of its tougher elements rejected. Notably, a proposal to pay for future bailouts by a special tax on the megabanks was dropped from the bill, and no provisions remain that would actively break up the systemically important institutions. The main thrust is to oblige banks to hold somewhat more reserve capital, and other small reforms, many influenced by the Basel Committee, which is negotiating international banking accords. The goal is to prevent another megabank bailout with the public’s money, but as Tony Jackson wrote in the Financial Times, “Governments may swear blind they will not stand behind bank creditors. But if the market correctly surmises official nerve will crack in a crisis, these protestations are worthless.”

The monumental growth of the largest banks owes a lot to the industry’s economies of scale and scope that developed once regulations were relaxed so firms could exploit them. While certainly not unique to finance, these dynamics have brought the banks to such enormous size that their bad bets can put the entire economy in peril. Banking therefore offers an especially powerful case for the importance of these economies and the role of market power, since it’s left the megabanks holding all the cards.

In fact, many arguments between defenders of the market economy and its critics center on the issue of competition vs. power—market boosters reliably insist that markets mean efficient competition, where giants have no inherent advantage over small, scrappy firms. However, the record in banking clearly shows that banks have enjoyed a variety of real benefits from growth. The existence of companies of great size and power is a quite natural development in many industries, due to the appeal of returns to scale and power. This is why firms end up with enough power to influence state policy, or such absurd size that they can blackmail us for life support—and leave us crying all the way to the bank.

grew big too, but it was because of those chewable vitamins. He’s an assistant professor of economics at Ivy Tech Community College in Bloomington, Indiana, and has written for Dollars & Sense, Z Magazine and The Humanist.

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