Five things to know about the size of banks

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Banks around the world come in all shapes and sizes. During the financial crisis, the term “too big to fail” was used a lot. But what does that mean? Here are five things to know about the size of banks.

1. Is bank size really a problem?

Larger banks can mean greater efficiency, profitability, and diversification. But if a bank grows too large, it may have the opposite impact and be less efficient, less profitable and more risky.

Many banks have acknowledged this, and have started to simplify their structure, their product range and their balance sheet. During the financial crisis in 2008-2009, being “too big to fail” and the potential consequences of bank failures for taxpayers and national economies in general became major issues around the world.

Since then, the Basel Committee on Banking Supervision has established a number of indicators to determine whether a bank is big enough to be a “global systemically important bank”, or G-SIB. These banks, including ING, are subject to additional supervisory requirements aimed at mitigating risk in the financial system.

2. Why do banks grow in size?

There are many factors driving bank growth:

  • Diversification: The benefits of having multiple unrelated sources of risk is a crucial reason for a bank to minimise concentrating on one area and to diversify into different activities, industries, and across borders.

  • Economies of scale: Banks have to make huge investments in IT infrastructure, and like most businesses banks have overhead, such as risk management, compliance, audit, and legal affairs. A bigger bank means “bigger” revenue and more money to cover investments and overhead, therefore lowering the costs per individual transaction - and ultimately lowering the charges for customers. As industry regulators make requirements more strict, compliance costs are increasing, making scale even more important.

  • The European market: Over the past 25 years, the prospect of a single European market has prompted an intense consolidation drive in the financial industry – meaning that banks increasingly merged or acquired one another.

  • ‘Synergy’: Banks have become ‘one-stop shops’ for financial services, which offers advantages for both the bank and the customer. For example, retail customers who are opening an account can be offered options for a loan, while corporate customers opening an account may also need help with a share or bond issue. There are many more potential benefits like these.

3. Why do banks fail?

Many assume that larger banks are more likely to fail than smaller ones, but size has very little to do with it. A lack of liquidity (the ability of a bank to meet its short term financial obligations) is not the ultimate reason either. In most cases, liquidity problems are a symptom and not the cause.

The real cause of a bank's failure is often because it has not diversified its risks well enough, instead, it has a large concentration of similar loans that generate problems or that are perceived by investors to be problematic. Diversification is just as important for small banks as it is for large banks because the concentration is relative to the total balance sheet of a bank.

The collapse of one concentrated position, or even the mere expectation among investors that it will collapse, can trigger a bank run, which is when many customers start to withdraw their money all at once. The bank will then struggle to attract money on the financial markets. If this spirals out of control, the bank’s reserves may not be enough to cover the withdrawals and the bank could ultimately fail, costing investors and other stakeholders.

A criticism of large banks is that they become “too big” to fail, because their failure could jeopardise the financial system. Imagine not being able to pay for groceries, or access a credit line for a business. Because of this, governments step in to prevent big banks from failing, which could pose a risk to taxpayers. This is called a bailout, which happened to some banks during the financial crisis and is something we want to prevent in the future.

4. How can this problem be solved?

Measures have been taken since the financial crisis to make it less likely for banks to fail and to limit losses for taxpayers should banks fail. The changes that were implemented all boil down to three lines of defence:

  1. Build a healthy bank, based on accurate risk management and avoiding excessive concentration in one area.
  2. The ‘recovery and resolution plan’. The recovery part of such a plan is a key element. It aims to have predefined emergency scenarios in place so that whenever problems occur, the bank can take measures at an early stage. If a bank fails despite these efforts, the resolution part of the plan ensures the fallout can be reasonably contained by protecting vital activities such as payments services and making sure they can continue as long as necessary.
  3. Once a bank has ended up in the resolution phase, the third line of defence will kick into action: ‘greater loss-absorption capacity’. This aims to ensure that not only shareholders but also creditors (such as certain bondholders) absorb losses so that savers are protected as much as possible and taxpayers are spared. This is called a “bail-in”.

5. What’s ING's ideal for the banking industry of the future?

To determine what the banking industry should look like in the future, we should first ask ourselves which services society needs banks to provide and then, what kinds of banks can best provide these services.

Different kinds of customers will require different kinds of banks. In our view, financial stability and the economy would be best served by a varied banking landscape: different kinds of banks in different sizes, specialised and diversified, domestic and cross-border, retail, commercial, investment, and universal banks. A landscape with small banks as well as big ones. Exactly how big still remains to be seen, but in any case, size shouldn’t be an issue for taxpayers.

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