What Uday Kotak should learn from Citi: Bigger banks can end up as liabilities

635266189203244874_Kotak Mahindra Bank
Over the weekend Pramit Jhaveri, the CEO of Citi India, had a thing or two to say about the size of Indian banks. He said that other than needing more banks, India needs bigger banks to compete on the world stage. “At this point, sensible consolidation would be one way to achieve scale,”
he said.
The comment comes right at a time when the Kotak Mahindra Bank has decided to acquire the ING Vysya Bank. The irony here is that Citigroup, of which Jhaveri is a part of, was rescued by the Federal Reserve of the United States from going bust, only a few years back.
The Fed came into rescue Citigroup because it was too big to fail. And if it had been allowed to fail, the repercussions would have been felt by the entire financial system.
The United States Congress passed the the Glass–Steagall Act in1933. This Act was passed after the stock market crash of 1929 and essentially drew a line between commercial banking and investment banking on the grounds that the riskiness of the latter would lead to the required safety and soundness of the former being compromised upon.

This made banking a very boring business with commercial banks having to stick to borrowing money from depositors, and lending it out, and making the difference in interest rates as their income. This meant banks which raised deposits could not trade in stocks and other financial securities. They could not get into the brokerage business either.
The Glass–Steagall Act was replaced with a new Act in 1999 (the Gramm-Leach-Bliley Act) to clear the merger of Citicorp, a commercial-bank-holding company, with the insurance company Travelers Group. This led to the formation of Citigroup, which was a company that had several different financial service brands under it. There was Citibank, which was a bank, Smith Barney, a stock brokerage firm, Primerica, a firm that sold insurance products and Travelers, an insurance company.
Long story short, what emerged was basically a very unwieldy company. A firm which was too big to fail.
On October 31, 2007, Meredith Whitney, an analyst of financial firms at Oppenheimer and Co., went all out against Citigroup. She said that the bank had so mismanaged its financial affairs that it would have to slash its dividend or go bust. The market heard out Whitney. The share price of Citigroup was down by 8.8 percent, to $38.51, by the end of that day.
Chuck Prince, the lawyer CEO of Citigroup, quit seven days later, on November 7, 2007. The stock price by then had fallen by 20 percent, to $33.41, from where it stood before Whitney’s pro­nouncement on the bank. What was interesting was the way Prince looked at things. Only a few months earlier, on July 7, 2007, he had said that things could get complicated in the days to come “But as long as the music is playing, you’ve got to get up and dance.” “We’re still dancing,” he had remarked.
The troubles for Citigroup just erupted after this. It had made huge investments in subprime securities and other financial securities using the structured investment vehicles (SIVs) route which started to go wrong (this story is too long to go into detail here). Once the financial crisis broke out in September 2008, the market did not expect Citigroup to survive.
But Citigroup was too big to be allowed to fail. On October 14, 2008, the treasury department of the United States (or what we call the ministry of finance in India) invested $250 billion in 10 financial institutions as a part of the capital purchase programme.
The Citigroup was a part of this and got $25 billion from the US government. After receiving the investment from the government, the then CEO of the firm, Vikram Pandit, said that the investment would give his firm more flexibility to borrow as well as lend.

But the market wasn’t too confident about the chances of Citigroup surviving, given its huge investments in subprime and other shady securities through the structured investment vehicle route.
The trouble was that like AIG, Citi was also deemed to be too big to fail. So, on November 25, 2008, the government decided to inject $20 billion cash into the firm. This was over and above the $25 billion that Citigroup had already received as a part of the capital purchase programme a little over a month earlier. The government also decided to guarantee $306 billion worth of troubled mortgages and other assets of the firm. And this is how Citigroup, like many other financial institutions was rescued by the government, simply because it was too big to fail.
A firm like Citigroup, which is present in a large number of financial service businesses as well as investment banking businesses, was and continues to be extremely unwieldy to manage. But, at the same time, the firm was so big and into so many different businesses that letting it go, would have led to a lot of job losses and other firms going bust as well.
To his credit, Alan Greenspan, who was the Chairman of the Federal Reserve of the United States from 1988 to 2006, had pointed out the risk of big banks as far back as October 1999. He had said in a speech that “megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail.”
Hence, it is important to make sure that there are no institutions which are too big to fail. As Bob Swarup puts it in
Money Mania,If the vanishing of an institution will destroy the network of our economy, it is too large to survive. Citigroup will one day go bust. Probability and evolution tell us that. Therefore, we can either keep trying to postpone the inevitable or remove that anomaly. This can be done over time by shrinking the institution through incentive or breaking up the institution.”
Interestingly, research carried out by the Federal Reserve has been unable to find any economies of scale of operation beyond a certain size. As Greenspan asks in
The Map and the Territory: “I often wondered as the banks increased in size throughout the globe prior to the crash and since: Had bankers discovered economies of scale that Fed research had missed?”
In fact, there is little to suggest that banks benefit from any economies of scale, when they grow beyond $100 billion in assets, suggest Anat Admati and Martin Hellwig in
The Bankers’ New Clothes. (On a different note Kotak Mahindra Bank had Rs 1,22,237 crore as on March 31, 2014. Hence, as far as economies of scale are concerned it is still well below Admati and Hellwig’s cut off point).
Moral of the story: bigger banks aren’t necessarily better, especially in an environment where governments cannot let a bank go bust in case it runs into trouble. As Swarup points out “No government will ever take the electoral risk of bank failure. Governments throw money at the problem, even if it is in vain, because the incentives are based on perpetuating their political hegemony.”
And this is something worth remembering every time a banker talks about bigger being better.

The article originally appeared on www.FirstBiz.com on Nov 25, 2014