Banking: Remember 'TBTF'? - Views on News from Equitymaster

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Banking: Remember 'TBTF'?

Sep 2, 2009

Stocks in Asia continue with their volatility led by China, which has been on a crash course of late. Stocks from the financial sector though continue to move up across the world. Take for instance the US, where, since the low of March 9, the S&P 500's financial sector is up around 137% as compared to S&P 500's overall gain of 52%. Even in India, the BSE-Bankex has gained 133% since its March lows, as against a 107% rise in the BSE-Sensex Investors are torn on how long the financial stocks' run can last. But many agree the sector's outperformance is a vote of confidence in the strength of the banking system and economic recovery worldwide. Now how strong or fragile is this banking recovery is what we doubt. Moreover, has the banking sector become any stronger since the crisis erupted is not clear.

Before we discuss any further, here is an old but interesting story of two friends who went to a jungle. They saw a hungry lion there. As soon as they saw the beast, they understood that they are going to be history. One of those guys took a pair of brand new shoes and started wearing them. His friend was surprised at his action and asked him, "Do you think that you can run faster than the lion with those shoes on?"

This guy replied him, "Dude, I need not run faster than the lion. I just need to run faster than you!"

So, what is the moral of the story? You have to be fast enough to survive in this competitive world. In the parlance of financial markets, you have to be TBTF!

TBTF? Sounds like something you have already heard earlier? Remember - 'Too big to fail'?

If you remember, TBTF is an idea that in banking regulation the largest and most powerful banks are 'too big to (let) fail'. This means those banks would have less incentive to practice thrift and sound business practices, since they would expect to be bailed out in the event of failure.

It was this very policy of TBTF that saved the likes of Wells Fargo, JP Morgan and Bank of America in the US (apart from the usual suspects like Goldman Sachs and AIG). This was while the 'too small to be saved' breed like Bear Stearns and Lehman Brothers were allowed to die (in some way or the other).

In fact, the TBTF kind of banks in the US were so big that when the credit crisis struck, the US central bank pumped billions of dollars into them. This is because it feared their failure would ruin the entire financial system.

But then, see what has been the result of saving these banking behemoths. They have grown even bigger. So they are now even bigger to let fail!

As the following chart shows, the market shares of total US bank deposits for big banks like Wells Fargo, JP Morgan, and Bank of America, are far higher than they were at the beginning of the crisis!

Top US banks' market share of deposits
Data Source: The Washington Post

These three banks, plus the government-rescued and now government-owned Citigroup, now issue one out of every two mortgages and around two out of every three credit cards in the US.

And now, regulators in the US are concerned about two key issues:

  1. Consumers will end up with fewer choices for services; and
  2. Big banks like these will assume they always have the government's backing if things go wrong...and thus, recklessness in lending and investments will continue.

India isn't spared either
Mr. Ajit Dayal, the founder of Equitymaster, wrote in an earlier article that India also has some live examples of the TBTF kinds. As he wrote, "IFCI, ICICI, and IDBI were all developmental financial institutions that lent good money to bad projects. By 1999 many of these financial institutions were in trouble. Why? Because there were a few larger business houses that owed them a lot of money and, since industry was in bad shape, no one could pay so these financial institutions were in trouble and needed to be rescued by a combination of money, change in management, or change in business strategy. Today, all 3 institutions stand alive - some prospering, some tottering. But they stand."

On the other hand, as Ajit wrote, "Over the same time period, many smaller banks and cooperatives have been shut down. These smaller banks made the same mistakes as the larger banks and institutions but they were not likely to have such a large impact outside a specific geographical area. So they were allowed to 'fail'."

There you have it. TBTF isn't the US, in India, everywhere!

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