TBTF Means TBTM (Too Big To Manage) Part II

Banks that are too big to fail or TBTF are by definition also too big to manage or TBTM. In Part II of the series we look at the role played by the growth of products and markets in this phenomenon. Part I can be found here.

What is it about the industry that makes banks so susceptible to becoming TBTM or too big to manage? As noted in Part I, egos and megalomania do play a significant part. However, they are definitely not the whole story.

For many bankers, performance is synonymous with size. Bankers take it as gospel that the greater their share of a particular product market, the greater the profits to be earned from that market. It is obvious that such a proposition does not necessarily hold true.

Part of the rationale for such thinking is that bankers also generally believe that the markets are a zero sum game. Consequently, every transaction is considered a win or loss for a bank vis-à-vis the competition and of course the converse is also true.

A byproduct of all this is that each time a new product is created banks rush in to get their share of the market—and then strive to dominate wherever and however possible. This therefore explains the well-known herd mentality that exists amongst bankers. It is one in which the market for newly introduced products and services grow exponentially, saturate and explode in pretty short order, often taking the banks and the industry down with them.

This is precisely what happened in the case of subprime mortgages, the product most responsible for the financial crisis. It is also precisely what happened in previous financial crises such as LDC debt, junk bonds, the Japanese asset price bubble and the Dotcoms. In each case, the herd mentality set in, the market grew exponentially, saturated and exploded in a relatively short period of time.

Merrill Lynch is just one example of a bank that went off the rails because it decided to run with the herd. When Stan O’Neal became CEO of Merrill Lynch in 2001, the firm was generally risk averse. Mr. O’Neal decided that this was not good enough and that Merrill Lynch should be challenging Goldman Sachs to become the preeminent investment bank. He therefore changed the culture of the firm by adopting a more aggressive risk profile.

Adopting a more aggressive risk profile at Merrill Lynch eventually involved plunging headlong into the one market that was all the rage at the time, subprime mortgages, as well as the credit derivatives which were associated with that market. This prompted one commentator in the New York Times to note:

“The mortgage business at Merrill Lynch was an afterthought—they didn’t really have a strategy.”

We all know what happened next—Merrill Lynch ran into trouble and ended up being taken over by Bank of America.

During my own career in investment banking I was integrally involved in developing strategies for many businesses and product lines. There were times when a head of business would approach and ask me to put together a strategy paper and/or presentation for a new product.

Naturally I would question them to determine the rationale behind this new product and how it would fit into the bank’s overall strategy. More often than not the response I got was that JP Morgan or Merrill Lynch or Goldman Sachs was already doing the product and so we needed to get involved. This invariably suggested that the business head in question had not properly thought through what the product meant for the bank, its strategy or its customers.

This is precisely how the herd mentality operates.

When taken together; the belief in the zero sum game, the urge to play follow the leader, the herd mentality and the almost suicidal growth in product markets have all underpinned the phenomenal expansion in the banking sector and the emergence of TBTF. Proof of the extent to which this is true is borne out by the fact that the banking sector went from 5% of US market capitalization in 1990 to 23.5% in 2007 (Mainelli & Giffords).

It is therefore no wonder that organizations that operate in such an environment have a tendency to grow very large very quickly, but not necessarily in a manner that is consistent with best (or even any) management practices. Hence they become too big to manage.

In Part II we have looked at the role products and markets have played in TBTF and TBTM. In Part III, we will look at the role customers.

Jonathan Ledwidge is the author of the book Clearing The Bull: The Financial Crisis and Why Banks Need a Human Transformation. The book is also now available in the Kindle / E-book format on Amazon / Barnes and Noble.

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