Banks’ Immensity Undermines Responsibility

Anat R. Admati is the George G. C. Parker professor of finance and economics at the Graduate School of Business at Stanford University and co-author of "The Bankers’ New Clothes: What’s Wrong With Banking and What to Do About It.''

Updated May 16, 2014, 10:52 AM

The largest financial institutions control trillions of dollars in assets, engage in numerous complex transactions daily and have thousands of subsidiaries and hundreds of thousands of employees across dozens of countries. Far from the “big is beautiful” image that some portray, these institutions appear to suffer from severe and persistent governance and control problems.

Banks have perverse incentives to grow larger, more complex and more opaque because investors believe policymakers won't let them fail.

The latest in a string of scandals involves JPMorgan Chase, which failed to fulfill its legal obligations to alert authorities to the Madoff scheme even as it “connected the dots when it mattered to its profits.”

Reports of billions of dollars in fines to settle suspected fraud, manipulation and other violations of laws and regulations by the largest financial institutions come with alarming frequency. These cases show a pervasive pattern of loose oversight. For example, the report of the Senate Committee of Investigation into the billions JPMorgan Chase loss in the London Whale trading scandal showed pervasive and severe breakdown in governance and regulation. The Libor and exchange rates manipulation by many large institutions provide further evidence. A recent paper uses Citigroup as “a case study in managerial and regulatory failures.”

The individuals responsible for the wrongdoing hardly ever face serious consequences. As the banks pay fines and promise to improve their control systems, too little appears to be changing.

How is all this possible? The answer lies at least in part in ineffective regulation and in the perverse incentives for banks to become ever larger, more complex and more interconnected. If investors believe that policymakers will not allow “systemic” institutions to fail (or even become severely distressed) for fear of disrupting the economy, the institutions can borrow under attractive terms that do not fully reflect the risks they take. Insured depositors entrust banks with their savings, counting on deposit insurance to come in if banks are unable to pay. The larger and more complex an institution becomes, and the more risk it takes, the more it is able to benefit from this situation. The banks’ gains, however, ultimately come at the expense of the public, and the resulting fragility and inefficiency of the system create great distortions.

Conglomerates that become inefficiently large and complex sometimes break as a result of market forces, but don’t hold your breath for the same to happen in banking. Unless better regulations and more effective enforcement change the incentives and create more accountability, we appear doomed to continue living with an unhealthy and dangerous system.