2011-2012 BETTING BIG 765 BETTING BIG: VALUE, CAUTION AND ACCOUNTABILITY IN AN ERA OF LARGE BANKS AND COMPLEX FINANCE* LAWRENCE G. BAXTER** Abstract Big banks are controversial. Their supporters maintain that they offer products, services and infrastructure that smaller banks simply cannot match and enjoy unprecedented economies of scale and scope. Detractors worry about the risks generated by big banks, their threats to financial stability, and the way they externalize costs of operation to the public. This article explains why there is no conclusive argument one way or the other and why simple measures for restricting the danger of big banks are neither plausible nor effective. The complex ecology of modern finance and the management and regulatory challenges generated by ultra-large banking, however, cast serious doubt on the proposition that the benefits of big banking outweigh its risks. Consequently, two general principles are proposed for further consideration. First, big banks should bear a greater degree of public accountability by reforming certain principles of corporate governance to require greater representation of public interests at the board and executive levels of big banks. Second, given the unproven promises of performance by big banks, their unimpressive actual record of performance, and the many hazards they inevitably generate or encounter, financial regulators should consciously adopt a strict cautionary approach. Under this approach, big banks would bear a very heavy onus to demonstrate in concrete terms that their continued growth – and even the maintenance of their current scale – can be adequately managed and supervised. * © Lawrence G. Baxter. ** Professor of the Practice of Law, Duke Law School. I wish to thank my research assistants, Daragh Murphy, Duke LLM 2012, for his energetic research and numerous helpful ideas, and Brian Berger, Boston University J.D. 2014, for his helpful research assistance. I would also like to thank Jim Cox, Lissa Broome, Ray Natter and Lucy Chang, Duke J.D. 2012, for their helpful comments on various drafts. 766 REVIEW OF BANKING & FINANCIAL LAW Vol. 31 Table of Contents Introduction ....................................................................... 767 I. New World of “Big Banking” ............................................ 778 A. “Deepening Global Finance” ........................................ 778 B. Big Banking .................................................................. 780 C. Big Banks ...................................................................... 781 1. Universal Banks ........................................................ 782 2. Retail and Commercial Banks .................................. 783 3. Investment Banks ...................................................... 783 4. Investment Servicers and Managers ......................... 783 D. Value of Big Banks ....................................................... 786 1. Efficiency .................................................................. 787 2. Capacity .................................................................... 812 3. Global Competitiveness ............................................ 816 4. “Instrumentalities of the State” ................................. 818 II. Public Costs of Big Banks .................................................. 825 A. Direct and Indirect Public Subsidies ............................. 827 B. Market Power and Repression of Competition ............. 831 C. Distorting Political Influence ........................................ 833 D. Costs of Regulation and Supervision ............................ 836 1. Evolving Dimensions of Risk ................................... 838 2. Basel II and the Failures of Institutional Risk Regulation ........................................................ 839 3. The Dodd-Frank Act and Basel III ........................... 845 III. Scale, Complexity and Financial Stability ......................... 848 A. Banks Are Indeed Still Special ..................................... 849 B. Complexity Science and New Perspectives on Risk Management ......................................................... 852 1. Essence of Complexity and Its Relevance to Financial Markets ..................................................... 854 2. Power and Fragility in Complex Financial Systems ..................................................... 857 3. Layers of Complexity in Financial Markets ............. 861 IV. Two General Consequences for Public Policy .................. 868 A. Public Accountability ................................................... 868 B. Progressively Tighter Restrictions on Bank Growth and Diversification ........................................... 870 2011-2012 BETTING BIG 767 Conclusion ......................................................................... 874 Appendix ............................................................................ 875 Chart 1 (Efficiency Ratio) ................................................. 875 Chart 2 (Return on Equity) ................................................ 876 Chart 3 (Return on Assets) ................................................ 877 Table 1 ............................................................................... 878 Table 2 ............................................................................... 879 “Companies big and small will still need underwriting, credit, capital management, and advice. McKinsey did a report that showed that the credit needs of multinationals are going to double in the next ten years,” . The net worth of the world is going to double in the next decade. Institutional funding will double in the next ten years. We’re a store, you can buy bonds, FX, advice—we provide great products at a great price. That store is not going to go away. If you’re a big, smart investor and we can give you the best price and the best service, you’ll still be coming here, just like Wal-Mart and Costco.”1 Introduction Big banks2 stir great controversy. They always have—more so since the worldwide financial and economic crisis of 2008 1 See Gabriel Sherman, The End of Wall Street As They Knew It, N.Y. MAG. (Feb. 5, 2012), http://nymag.com/news/features/wall-street-2012-2/ (quoting Jamie Dimon, CEO of J.P. Morgan Chase & Co., describing his vision of the future of banking). 2 For stylistic purposes, this article will refer variously to “big banks,” “universal banks,” “large, complex financial institutions” (“LCFIs”) and other terms designating different kinds of very large financial institutions. These are described more fully later. See infra text accompanying notes 52- 77. All of them share, or have the potential to share, one common characteristic: as a result of the scale and complexity of their operations, they can have a critical impact on financial stability. See infra text accom- panying notes 326-336. 768 REVIEW OF BANKING & FINANCIAL LAW Vol. 31 (“Financial Crisis” or “Crisis”)3—and probably always will. Few names ignite debate more quickly than those of financial institutions such as J.P. Morgan Chase, Citibank, Goldman Sachs, or Bank of America.4 Partisans of the right and the left unite in condemning bank bailouts, the compensation bank executives receive and the political power banks wield. For years, many informed individuals have worried that these financial behemoths have grown too large, too powerful, too complicated to regulate and too dangerous for global and domestic financial stability. These critics include politicians,5 leading regulators,6 economists and commentators 3 Various terms have been used to describe the Financial Crisis, depending on whether one is focused on the United States economy or the global impacts (in which case the term “Global Financial Crisis,” of GFC, is often used). The domestically focused term will be used in this article. 4 Throughout this article the following abbreviations may be used: “Barclays” for Barclays PLC; “Bank of America” for Bank of America Corp.; “Citi” for Citigroup Inc.; “Deutsche” for Deutsche Bank AG; “Goldman” for Goldman Sachs Group, Inc.; “JP Morgan” for JP Morgan Chase & Co.; “Lloyds” for Lloyds Banking Group Plc; “Merrill” for Merrill Lynch & Co, Inc.. (now wholly owned by Bank of America); “RBS” for Royal Bank of Scotland Group Plc; “Wells” for Wells Fargo & Co. A specific reference to any particular component of these conglomerates will use the legal title. 5 During the major debates leading to the passage of the major statute on financial reform in the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), Senator Bernie Sanders unsuccessfully introduced a bill entitled “The Too Big to Fail, Too Big to Exist Act of 2009,” designed to impose limitations on bank size. Too Big to Fail, Too Big to Exist Act of 2009, S. 2746, 111th Cong. (2009). Subsequently, Senators Sherrod Brown and Ted Kaufman also unsuccessfully introduced an amendment that would have imposed limits on LCFI size. Press Release, Sherrod Brown: Senator for Ohio, Brown, Kaufman File Amendment on Too Big to Fail Legislation (Apr. 29, 2010), available at http://brown.senate.gov/newsroom/press_releases/ (search “Brown, Kaufman File Amendment on Too Big to Fail Legislation”, follow the hyperlink by the same name). Congress included in the final version of the Dodd-Frank Act the so-called Kanjorski Amendment, which authorizes the Board of Governors of the Federal Reserve System (“Fed”) to order divestiture of assets and subsidiaries where it believes that