Too big to Fail

There were many indignant voices in media during the financial crises when the biggest financial institutions were bailed out by the governments. Many argued that the well paid executives were taking too large risks to get outrageous bonuses during good times, knowing that their institutions were critical to the financial system and thereby too large to be allowed to fail during hard times. I will not defend the accused executives or for that matter dwell on the moral hazard in having institutions that are considered too big to fail. But, I will argue that the compliance fury that we have seen lately actually will reinforce the desire to become larger than competitors. The increased costs for ensuring compliance to new legislations are rapidly becoming one of the largest drivers for gaining economies of scale in the industry.

Aite Group has estimated the operational cost of compliance for the 100 largest banks in the US to a mind boggling $ 1 billion. Annually! Their breakdown on the compliance toll is really interesting. I used their estimate on the average annual compliance cost for the banks in the different size categories to calculate a new ratio, the compliance costs relative to assets. The result was really revealing. It is evident that there are economies of scale in ensuring compliance as presented in the graph below:

It is ironic that governments that complained about the vulnerability in the financial system with few, very large financial institutions are enforcing new regulations that favor the largest players. A bank with $ 500 billion in banking assets is having a relative cost benefit to the smallest bank ($ 5 billion) with 40%. I doubt that the governments want to promote Mergers & Acquisitions as a way to minimize the vulnerability in the financial systems, but that is actually what a top executive focusing on shareholder value has to consider in this regulatory driven new normal.

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