Line of Inquiry: Kilian Huber on Who Benefits When Banks Get Bigger

So since the financial crisis, 2008, 2009, there’s been a lot of debate about what the financial system should look like—what a safer, more stable financial system should look like. And in particular, there’s a debate about the role of bank size, so how large the biggest institutions should be, and should we, in some sense, stop banks from growing bigger all the time?

What we’ve seen in most advanced economies in the last three to four decades is a pretty continuous growth in the size of banks. The market share of the 10 largest US banks in 1990 was around 25 percent. And today, it’s grown beyond 60 percent, nearing 70 percent. So big banks are getting bigger—certainly in the US, they’re getting bigger all the time.

And policy makers have limited the growth of bank size a little bit in recent years. So they’ve introduced policies that make it harder for big banks to keep growing. For example, they’ve put tighter regulations on mergers. They’ve raised capital regulations on large banks. And all these factors have somehow limited the growth of large banks.

But there’s a big question about whether we should be doing this. In particular, classic economic theory, classic banking theory suggests that the larger the bank, the better the bank. Classic models will tell you these banks will do better for themselves, they’ll be more efficient, the economy will grow faster if we have larger banks. Firms will get more credit. Households will be able to borrow more cheaply and buy houses or other consumption goods. And so, overall, we think that perhaps there’s an argument that large banks should be allowed to continue growing bigger to exploit these potential efficiency gains.

Now, it’s very difficult to answer the question, should banks be getting bigger, and what happens when banks get bigger? And the reason is that banks may be getting bigger for their own reasons. They might be merging. They might be trying to acquire other banks and grow larger. But they might also be getting bigger for natural reasons. For example, as the economy is growing, firms and households want more credit, and therefore the size of the bank balance sheet grows.

And so, if we really want to understand the causal impact of what happens as the bank gets bigger, holding everything else constant, we need some kind of shock to the banking system, some kind of shock to the size of banks that has nothing to do with what’s going on in the real economy. And in general, academics and policy makers have struggled with this question, and they’ve struggled to identify a setting where there’s really a shock to the size of banks that we can trace through the system, where we can figure out what happened when these banks got bigger for reasons that have nothing to do with what was going on in the real economy.

What attracted me to studying postwar Germany and the postwar German banking system was that we have a shock to the banking system where some banks got bigger for reasons that were unrelated to what was happening on the ground in the economy. And this reason was legislation by the Allies, by the postwar occupiers of postwar Germany. The Allies believed that large banks were harmful for the economy, that the largest German banks had contributed to the war effort and to the rise of the Nazis and to this horrible destruction upon the world that the Nazis brought. And so the Allies wanted to restrict bank size. They wanted to make sure that these large banks wouldn’t be able to finance and support another war government in Germany.

And so what they did was they broke up the three largest banks that had been particularly closely associated with the Nazi regime, and they forced these banks to operate in separate regional parts. So instead of one national Deutsche Bank, for example, in 1946, ’47, there were now 10 separate Deutsche Banks across Germany and across German states. And each of these banks that was a Deutsche Bank successor was not allowed to cooperate with the other Deutsche Bank successors. It was supposed to have its independent balance sheet and its independent decision-making.

And then after a while, as the Germans became more friends with the Allies and as the Cold War was rising, the Allies became a bit more open to German wishes about how to restructure the German economy. And so, in 1952, they allowed the banks to partially reconsolidate. So for example, let’s think about Deutsche Bank again. Instead of 10 state-level Deutsche Banks, there were now three regional-level Deutsche Banks. So different parts of the Deutsche Bank organization were allowed to consolidate and become slightly larger banks.

And then, by 1956, it became clear that Germany was really becoming an ally of the West in the Cold War. The Americans, French, and British decided to leave Germany and make it a sovereign country. And the German government had always believed in the power of big banks, so unlike the Allies, they wanted large banks to be there. And so as a result, they actually lifted all the legislation that the Allies had imposed. And by 1957, there were once again three large banks with a national branch network, for example, one large Deutsche Bank that had been formed of the three regional entities.

So when you wake up one day in 1952, instead of having a state-level bank, we now have a much larger regional Deutsche Bank. And then you wake up one day in 1957 and instead of three regional banks, there’s now one large national Deutsche Bank. And so I ask the question, what happened to firms? What happened to households and other forms of borrowers that were reliant on these banks that were subsequently growing bigger again after the war?

So I specifically look at these two episodes, 1952 and 1957, when these broken-up banks in this two-step procedure became large again, and I try and understand what happens on the ground to firms, to households, to regional economies when the size of the banks jumps up by a factor of three or four overnight. I came across large historical volumes in various archives across Germany that collected data on the financial performance of banks, of individual banks, as well as the performance of firms that these banks were lending to. And so with a team of research assistants and a data entry company located in India, we started just typing up whatever was in those books, typing up numbers on how the banks were growing and how the firms were growing, and in particular which firms were linked to which banks.

So I find that on average, firms that were reliant on the banks that were getting bigger did not benefit in any way. They did not grow any faster. They didn’t make larger profits. They didn’t hire more employees. They didn’t take up more bank debt. So overall, it looks like, on average, it didn’t really make such a big difference to firms whether their bank was large or relatively small.

But there are some interesting subtle results once you explore the data in more detail. For example, if you’re a relatively small firm, then you actually were worse off when your bank became bigger. And that may be surprising at first, but if you think about it carefully, if you think about how banks and small firms interact, perhaps it makes more sense.

So in particular, small firms rely on close personal contact between the banker and the entrepreneur. They rely on personal advice. They rely on being able to get credit without having a huge credit history and large documentation and firm size to show for. And so as institutions become bigger, as banks become bigger in particular, we think that banks lose that personal touch a little bit. They rely more on algorithms and strict rules and who gets credit and who doesn’t and less on the feel of the banker on the ground.

And so for small firms, for young firms, for firms with few assets, that became a problem. And they actually grew more slowly when they were attached to a previously small bank that now became bigger over time. And if you then aggregate up and you think about regional economies, the growth of towns, cities, urban regions, it turns out that we find negative effects. So overall, the impact, the negative impact on these small, young, and low-asset firms dominated. And so overall, regional economies grew more slowly if they were more dependent on the large banks. And so that’s pretty interesting because it’s in sharp contrast to what standard economic theory would suggest, at least what the basic models of banking suggest.

Also on the banks’ side, there weren’t huge benefits. So it’s not like these banks were becoming more efficient in their financial ratios or in their profitability. If anything, they grew roughly at the same rate as the other banks and lent out a little bit less than the other banks that were not affected by these policies.

There were a few individuals that did benefit—in particular, the individuals that were pushing for increases in bank size. The managers, the members of the supervisory and executive boards, they ended up making more money. They earned larger salaries as the size of the bank was increasing. They also appeared in the media more often. They were asked more about national events or economic developments, and so on.

So if we think that both salaries and media presence might be beneficial to bank managers, then that might explain why in general we see banks consolidating a lot. It seems to be the case that there is some benefit on the banking side. But it’s just not for the organization overall, but it’s for the particular managers that were running the organizations.

So when you think about the modern-day policy implications of this paper, you have to be careful because obviously we’re talking about 1950s Germany. We’re talking about a very different kind of banking system, a much more traditional kind of banking system, where banks are interacting with firms and households on the ground. They’re lending and they’re taking deposits. Now, banks nowadays do many different things, but they still do some of that traditional stuff.

And so at least as far as the traditional activities of banking is concerned, I think we can learn something from this paper. We learn that there’s not an automatic magic wand that large banks possess that allows them to be much more efficient and serve the real economy much better. We learn that simple ideas of how banking works and the sense that the larger the bank, the better the bank, that these ideas aren’t quite true as generally as they’re sometimes supposed to be true. So if you ask banking lobbyists or bank managers, they’ll often tell you that there are these magic economies of scale. As the scale of the bank increases, the bank just becomes better in general. Now, this paper clearly shows there was an instance where this didn’t happen, where banks actually became less efficient and harmed the real economy by getting bigger.