When a lapse in concentration is no bad thing

Is safety found in size, or numbers? It’s a question worth asking in light of new datasets pointing to one inescapable conclusion: the stability of the global financial system depends on the health and vitality of just a handful of massive, interconnected firms.

Take the US repo market. In September, it plunged into chaos and order was only restored after the Federal Reserve pledged to lend out tens of billions of dollars for weeks on end. One reason for the debacle was the extreme concentration of excess reserves in a few bulge-bracket dealers: Citi, Bank of America, JP Morgan and Wells Fargo.

Then there’s the derivatives markets. Data published by a European watchdog found that just five financial institutions accounted for almost half the notional outstanding in credit and currency derivatives in the European Union in 2018. In the US, it’s even worse. The Office of the Comptroller of the Currency reports that JP Morgan, Citi and Goldman Sachs alone account for 57% of the $270 trillion of derivatives notionals held by the top 25 bank holding companies.

The concentration of essential activities in a tiny cadre of super-banks renders the entire financial system vulnerable if one of their number should fail. There is no firm, or even group of firms, that could step in to take the place of JP Morgan if it suddenly imploded. Yet the benefits of scale in wholesale banking and capital markets inevitably leads to greater concentration.

The Basel Committee’s systemic risk framework imposes penalties on colossal lenders to curb their growth, but not to shrink down. Research by the Bank for International Settlements found that global systemically important banks have simply expanded more slowly than other banks.

There is no firm, or even group of firms, that could step in to take the place of JP Morgan if it suddenly imploded

Instead of breaking the oligopoly at the summit of the financial system, regulatory reforms have forced these financial titans to ‘self-insure’ for their own destruction, by loading on capital requirements, bail-in debt quotas, stress tests, living-will requirements and more. The hope is that these banks, so crucial to the smooth running of the financial system, will be so well fortified that they’d be untouched by another global financial crisis.

Some worry this enshrines ‘too big to fail’ rather than ending it. Regulatory policy is increasingly formed around specific, systemic entities instead of in the interests of the system as a whole.

For example, because of its importance in US money markets, JP Morgan is de facto the world’s lender of next-to-last-resort (just ahead of the Fed). Following the repo crisis in September, the central bank took steps to replenish banks’ excess reserves. This does nothing to address the underlying, systemic problems in the money markets. Instead, by cementing the uneven distribution of reserves, it simply shunts responsibility for greasing money markets back onto JP Morgan.

Regulatory capture is the logical endgame of a financial market philosophy that hallows too-big-to-fail firms. To keep the financial markets humming, the very largest companies need to be taken care of. But the more they are, the more important they become to keeping the show on the road.

It will take brave policy-makers, regulators and politicians to break the cycle.