In a blog posted today on the New York Times’ Web site, Simon Johnson, the former chief economist at the International Monetary Fund (IMF), questions a large U.S. financial institution’s plan to expand global transaction services in emerging markets:
"Transaction services are important, but they do not require a very large balance sheet; these can equally well be performed by a network of small, nimble financial firms…And emerging markets are risky…Probably there will be relatively good profits for a number of years…But when the cycle turns against emerging markets, as it did in 1982, what happens?”
Mr. Johnson’s observations are reasonable, but have nothing to do with the size of the institution pursuing business in emerging markets. Perhaps small firms can competently deliver transaction services, but does that fact imply that larger institutions either can’t or shouldn’t also participate in a profitable market opportunity? As for his warning about the potential ebbing of emerging market vitality, all markets – whether nations, regions, equities, bonds, real estate, etc. – change over time as they evolve and mature. Navigating such changes and effectively managing the associated risks is the essence of professional finance.
Mr. Johnson’s fundamental complaint is that he simply doesn’t like large financial institutions. He seems to recognize no unique value provided by large, diversified institutions, and claims that the orderly liquidation of a large institution is a myth.
In fact, exactly one month ago, on October 17th, the Federal Reserve finalized a new rule requiring the nation’s largest banks to establish “living wills” – precise blueprints of complex institutions coupled with detailed plans for their swift and orderly dismantling in the case of failure. The rule, a key provision of the “orderly liquidation” section of the Dodd-Frank financial reform law, was drafted jointly with the Federal Deposit Insurance Corporation (FDIC), which approved the same rule in September. By putting in place an explicit, predetermined wind-down plan, regulators will be in a much better position to isolate and manage the failure of a large financial institution while protecting the overall system.
As for the broader value of large and diversified financial institutions, such companies are uniquely capable on a number of important fronts. In the context of emerging markets, large globally active financial institutions have expanded the supply of credit and other financial services to emerging market economies, contributing importantly to the expansion of trade flows, opening foreign markets to U.S. goods and services and, therefore, contributing importantly to economic growth and job creation.
Large institutions active in many markets and many countries across the globe have also served to integrate global stock, bond, and foreign exchange markets, making those markets more modern, liquid, and efficient.
Large institutions provide significant value to customers – in the sheer size of credits they can deliver, in the array of products and services they can provide, and their geographic reach – that smaller institutions simply cannot provide. This unique economic value is particularly important to large, globally active U.S. corporations and contributes directly to economic growth and job creation.
Large institutions are also far more diversified in their business mix and revenue streams as compared to smaller institutions, which tend to be engaged in fewer business and regions and, therefore, are exposed to greater concentration risk. In this regard, larger institutions are more stable than smaller institutions. Rather than being a source of risk, size and diversity of activities can be a risk mitigant.
Research conducted by Columbia University finance professor Charles Calomiris shows that the gains produced by efficiencies of scale and scope accrue to customers in the form of better and cheaper financial services.
To be a global financial leader – an enormous strategic advantage for the U.S. economy and American businesses, workers, savers, and investors – the United States needs institutions of all sizes, business models, and areas of expertise.
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