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By Bo Cutter, originally published on Next New Deal

An obsession with the largest economic players distracts us from the smaller companies that should drive our future economy.

Both Richard Fisher, the president of the Dallas Federal Reserve Bank, and Alan Blinder, arch-economist and former vice-chair of the Federal Reserve Board, had fascinating commentaries last week on "too big to fail," the big banks, and financial stability. Fisher's was a reform proposal; Blinder's a set of lessons to remember. Both dealt explicitly or implicitly with our cult of scale. 

The business, popular, political, think tank, and NGO cultures of America are all infatuated with big enterprise and its leaders. As a society, we pay ritual and theoretical attention to small business and entrepreneurs, but with a very few exceptions we court big company CEOs almost exclusively. Every presidential economic statement or study has its requisite CEO centerpiece. When presidents (of all political persuasions) want to show that they are really, really serious about the economy, they have pictures taken of themselves with big company CEOs. The most frequently quoted business organization, the one whose policy pronouncements are taken as the last word in economic wisdom, is the Business Roundtable -- the insiders club for big business CEOs. The big news talk shows always have big business CEOs as their private sector representatives. The lobbyists whom congresses and governments pay attention to are from the biggest businesses. The same set of CEOs are always invited to presidential state dinners for visiting heads of state. The board development committees of think tanks, NGOs, and foundations covet the same set of CEOs. 

Why? 

Certainly not because big businesses play an actual dominant and dynamic role in our economy. Essentially 100 percent of all new jobs in America are created by new medium and small businesses. Even though large companies dominate R&D spending, revolutionary breakthroughs come almost exclusively from small entrepreneurial companies. If you look back just at the business history of the last 20 years, the pathbreaking innovations were always driven by small and medium companies -- never by the giant incumbents of an industry. 

So what benefits does scale bring us? Richard Fisher raises this question dramatically in the case of banking. Banks with less than $10 billion in assets -- 98 percent of all banks -- held only 12 percent of total bank assets in America but they made 51 percent of all small and medium business loans. Banks with less than $10 billion in assets continued lending to these businesses during the financial debacle; the big banks stopped. Lending, I'll remind you, is basically what banks are supposed to do.

And of course big banks are the riskiest and most costly part of the banking sector. Their failures or near failures nearly cratered our economy, they received the vast bulk of the bailout money, and they continue to hold the riskiest assets. The five largest banks in America hold $4 trillion in non-deposit liabilities, 26 percent of U.S. GDP. Among other problems posed by these liabilities -- for example, that virtually no one understands them -- they are the reason for the excess leverage of the big banks.

Blinder usefully underlines 10 commandments for avoiding the next financial crisis. They all make sense. But when you look closely at his commandments, at least eight out of 10 are directly linked to unavoidable problems of scale and complexity. Consider this: the five biggest banks operated through over 19,000 subsidiaries in a minimum of 50 countries each. The simple fact is that Blinder's very intelligent commandments can't work in this world. I begin with a prejudice: compared to the directors of the five giants (and these are highly sought after and highly compensated directorships), directors of America's smaller community banks are every bit as smart,  know more about the banks they direct, hold the CEOs of their banks in far less awe, are much more likely to discipline their management effectively, and are closer to the customers. None of this is just a role of the dice. According to Richard Fisher, J.P.Morgan Chase has about 5,000 subsidiaries. I'll grant that many of these are meaningless. But no set of directors on earth can really understand or guide well an entity with thousands of subsidiaries. In these circumstances, the amount of arbitrary, mostly unchecked authority given to senior management and the CEO is enormous. A single director is rarely going to risk either losing his or her directorship or simply being humiliated in the club by challenging the CEO on anything.

Which gets me back to the general problems of mega scale in business. While the biggest banks pose particular problems and the biggest dangers, all the evidence seems to say that as businesses get very, very big, four developments are inevitable. The businesses become sclerotic and bureaucratic. The businesses lose the creativity and dynamism that initially drove them. The businesses become extraordinarily complex. The businesses become less market-driven and more dominated by CEOs with a fair amount of arbitrary power. Some businesses and some extraordinary leaders -- Steve Jobs -- delay all of this, but the trends are inevitable. 

So once again, why the fascination with big companies and their chiefs? Awe, power, and money. The heads of the biggest companies are the real masters of our universe. They are treated like heads of sovereign states. A lot of them think of themselves that way and, in fact, a heck of a lot of big company CEOs have more actual power than the heads of government of all but 30 to 50 countries. And within a range the power is fairly arbitrary. The biggest companies have the widest range of  choices about products, locations, suppliers, public and community relations money, and foundation money. There is lots of economic "rent" buried among all those choices and everyone wants a little bit of it. I think the resources most big companies allocate through these choices mostly do an enormous amount of good and have a significant function in our strange society, but that's not the same thing as believing these companies are the future of our economy.

To be clear, big companies play big, real, valuable roles in our economy. We need a mix. But the balance has gone too far in our infatuation with bigness. The true path to the Next American Economy does not go in that direction. We will not grow as fast as we must with an increasingly big company economy. Equity and social mobility won't increase that way. We will need more breakthrough innovation, more new companies creating good jobs, more highly specialized value-added products and services, and more diversity and localization of businesses. The dream should be an economy driven by thousands of companies growing from dozens of very different urban platforms, not by a few dozen giants. But achieving that dream will be much harder if our political and intellectual culture is perpetually fascinated and seduced by the non-economic glamor of the wrong part of the private sector. 

Roosevelt Institute Senior Fellow Bo Cutter is formerly a managing partner of Warburg Pincus, a major global private equity firm. Recently, he served as the leader of President Obama’s Office of Management and Budget (OMB) transition team. He has also served in senior roles in the White Houses of two Democratic Presidents.


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Comment Preferences

  •  Excellent analysis (2+ / 0-)
    Recommended by:
    offgrid, bobswern

    I'd like to read a sequel to this—something solution-based that would level the playing field when the little guys take on the big guys in a sector, ways to encourage more boot-strap start-ups (not necessarily all tech) than we are seeing now.

  •  Bo - what policy changes can we make (1+ / 0-)
    Recommended by:
    bobswern

    that would support the nurturing of small and medium sized businesses?

    "let's talk about that"

    by VClib on Tue Jan 22, 2013 at 10:07:01 AM PST

    •  Read the entirety of Fisher's commentary... (1+ / 0-)
      Recommended by:
      Cassandra Waites

      ...which calls for the break-up of the TBTF banks in the link in this post. (This does not mean we put them out of business, by the way!)

      Additionally, IMHO, there are some exceptionally "captured" pieces of regulatory legislation/law which need to be reformed, drastically, starting with turning the clock back more significantly upon federally-chartered bank PREEMPTION! (See blockquote, below.)

      (NOTE: Dodd-Frank is helping to accomplish this, to some extent. But, when it comes to usurious credit card interest rates, there's still a substantial fight to be had.)

      ...In 1996, the OCC, through its regulatory power, paved another avenue for national banks to bypass state consumer protections by redefining what is "interest" as used in the National Bank Act. Now national banks are able to export bank fees such as late fees, fees for exceeding a customer’s credit limit, fees for making payment with a check drawn on insufficient funds, membership fees and other fees Aconnected with credit extension or availability" (2) from their home states to other states.

      This expansion of what constitutes "interest" coupled with recent interstate banking legislation seriously curtails State representatives’ and agencies’ ability to protect their citizens from excessive and oppressive penalty fees. In 1997, Congress adopted changes to the Riegle-Neal Interstate Branching Act which have the practical effect of exempting all but state-chartered banks from state consumer banking laws. The new law permits out-of-state banks to ignore consumer banking safeguards whenever a national bank may do so. As a result, those states that subordinate consumer interests to those of the banking industry can set the terms for items such as interest rates and fee terms for other states since national banks and out of state banks are able to side-step the host state’s consumer banking laws in these areas.

      The end result is a chipping away at the protections afforded in the Interstate Banking and Branching Efficiency Act of 1994, which emphasized that the host state’s laws regarding community reinvestment, consumer protections, fair lending and the establishment of intrastate branches would apply to interstate branches of national banks...

      Bringing back Glass-Steagall and making sure real teeth are put into derivatives trading oversight are examples of other critical areas of much-needed reform, IMHO.

      I've written a fair amount on these absurdly consumer-unfriendly laws, in particular. (And, if the public was better-informed about this, there would certainly be more pressure to change this.)

      Sounds like a perfect area of focus for the new Consumer Finance Protection Bureau (CFPB).

      "I always thought if you worked hard enough and tried hard enough, things would work out. I was wrong." --Katharine Graham

      by bobswern on Tue Jan 22, 2013 at 10:30:43 AM PST

      [ Parent ]

      •  bob - I don't see how any of those directly help (2+ / 0-)
        Recommended by:
        nextstep, Roger Fox

        nurture small and medium sized businesses. While some of the proposals have merit, your comment deals with an entirely different question than the one I asked.

        In my conversations with community and regional banks they state that the new rules under Dodd-Frank encourage them to sell to a TBTF multinational. The administrative and reporting requirements under Dodd-Frank are easy for big banks with entire departments and IT resources for compliance. The requirements are overwhelming local and regional banks. That's why acquisition activity is accelerating and we are losing our small banks at a rapid pace.

        "let's talk about that"

        by VClib on Tue Jan 22, 2013 at 10:36:20 AM PST

        [ Parent ]

        •  Let's talk about consumer finance, using... (1+ / 0-)
          Recommended by:
          Roger Fox

          ...the State of Arkansas as an example. (Consumer finance is one of the key areas in which I work, on a daily basis, with not just the TBTF's, but smaller lenders, as well.)

          While auto finance and student loans abound these days (I'm not going to get into this in this comment, but, there's plenty to talk about here), the reality is the TBTF's have stripped some $2 trillion in consumer credit from the public (approx. 40% of all available consumer credit), since 2008. (They've been encouraged to do this by default, since these TBTF's are enabled to gamble with their own money and invest it elsewhere, including outside of the country, to a great extent...all at the expense of the taxpayer, which guarantees this risky behavior.)

          Each state maintains their own usury laws (and caps) and this holds true for the TBTFs (i.e.: the leading consumer credit card issuers in this country), in term s of their ability to import rate from the "home state" of their consumer credit card operations (usually South Dakota or Delaware), as opposed to being subject to the laws of the individual states.

          If you go into a major chain store in Arkansas, and you seek financing from the store for your purchase, 99 times out of 100, you'll be handed a credit application (these days, it's more than likely going to be from either: Wells Fargo, GE Finance/Capital or TD Bank).  The credit annual percentage rate will, more than likely, be somewhere around 27.99% to 29.99%.  And, this is due to preemption laws which favor nationally-chartered banks over state banks. If it's occurring in Arkansas, for instance, the state banks are capped-out at roughly 12%-13% annual rates that they're allowed to charge on credit cards, due to very consumer friendly finance laws, as far as interest is concerned. But, the nationally-chartered banks don't have to play by those rules.

          Due to a myriad of TBTF-friendly laws, the TBTF's are enabled to make MUCH larger profits on consumer credit, drive better bargains with the card-issuers (i.e.: Visa, MC, etc.), and spend oodles more money marketing themselves everywhere, including Arkansas. They drive sweetheart deals with the big box stores, further cementing their positions as the "first-look lender" in these stores, nationally, too. And, the community banks face a sisyphean struggle just to get their foot in the door! (The big-box retailers are only concerned with their "vig" from the TBTF's on the issuance of credit cards, a game the local lenders cannot "play," simply because they are capped-out by the state on their lending rates.)

          This is just one of the many, many ways that the federally-chartered, TBTF's maintain an upper leg on their community bank/state-chartered counterparts. (Enabling primary dealers to obtain money at lower rates than their smaller counterparts, which further increases their profitability/profits, as well.)

          At the end of the day, the local banks and the consumer(s) gets screwed.

          There is a grossly uneven playing field in place on Main Street which dramatically favors the TBTFs' actions throughout the country. Again, At the end of the day, the local banks and the consumer(s) get screwed; and, the TBTF's pillaging continues.

          And, for the record, the TBTFs are using the exact opposite argument as they defend their status with regard to preemption (and why they "need" it), stating that complying with local lending rates would be too expensive for them to operate in the respective states. Which, as you so well-noted in your last comment, makes these TBTFs' claims total bullshit.

          "I always thought if you worked hard enough and tried hard enough, things would work out. I was wrong." --Katharine Graham

          by bobswern on Tue Jan 22, 2013 at 11:11:40 AM PST

          [ Parent ]

  •  Awesome post! I'm in the midst of writing a... (1+ / 0-)
    Recommended by:
    psnyder

    ...post which features, among other things, Fisher's commentary (your analysis of which, when tied-in with Blinder's commentary, is nothing short of exceptional). And, this was most helpful!

    Thank you very much!

    "I always thought if you worked hard enough and tried hard enough, things would work out. I was wrong." --Katharine Graham

    by bobswern on Tue Jan 22, 2013 at 10:13:17 AM PST

  •  Excellent, TnR (0+ / 0-)

    Super size no longer fits all.

    FDR 9-23-33, "If we cannot do this one way, we will do it another way. But do it we will.

    by Roger Fox on Tue Jan 22, 2013 at 12:28:10 PM PST

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