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HPSinsight.com July 15, 2012

HPSInsight Small U.S. Banks in a Big World?

By Tony Fratto, (202) 822-1205, tfratto@hamiltonps.com

The financial needs of individuals and companies around the world have grown exponentially in recent decades explosive growth, far exceeding the rate of global economic growth. And were not talking about derivative products, but debt and equity instruments expanding throughout the globe. Not only is this global market astonishingly large today, its only going to get much larger in coming decades. As we see economic growth in large emerging markets like China, India, Brazil and Nigeria, and hundreds of other smaller markets in addition to continued growth in large developed markets were going to continue to see a need for financial intermediation. As the volume of trade expands across the globe, including exports by U.S. firms, the need for global banking will grow. Its about the only sure thing as you can bet on today. A question for policymakers is Who is going to do all that banking? The small bank advocates otherwise smart and well-intentioned people are apparently unable to conceptualize the sheer massive needs of global finance, and instead imagine a world where small, local banks can do this work. So just at the time when financial institutions with the global networks and scale are most needed, we see breathless new calls to cap the size of banks in particular, U.S. banks. Simon Johnson recently argued that global banks should simplify along national lines. Dallas Federal Reserve President, Richard Fisher, and former Kansas City Fed President (and current FDIC commissioner), Thomas Hoenig, each call for breaking up banks. Theres an almost nostalgic, Lake Woebegone quality to their policy guidance. What these calls ignore is the fact that these institutions provide services that are in high demand around the globe, not just the U.S. In fact, its hard to see how the global economy could efficiently function absent big, global banks. For the U.S, it would mean forfeiting our ability to compete in this rapidly growing global market.

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Here are the facts: Since 1990, the global stock of financial assets has grown four times the rate of the global economy. In nominal terms, this translates to over a 1000 percent increase. Exhibit!1 !

THE GLOBAL STOCK OF FINANCIAL ASSETS HAS GROWN 4 TIMES THE RATE OF GDP OVER THE PAST 20 YEARS!
Global Financial Stock as a Percent of Global GDP! 220! 200! 180! 160! Stock Market ! Capitalization! Public debt securities ! outstanding! Financial institution ! bonds outstanding! Nonnancial corporate ! bonds outstanding! Securitized loans ! outstanding! Nonsecuritized loans ! outstanding! 1990!
Source: McKinsey Institute!

Percent of GDP!

140! 120! 100! 80! 60! 40! 20! 0! 1995! 2000! 2005! 2010!

This does not reflect the growth of complex derivative products only the value and volume of portfolio investments, private and official credit instruments and new capital markets in Asia, Latin America and Africa. More broadly, the data underscores how economic growth is trending towards the deepening of financial markets throughout the globe. The data also highlight that the financial needs of the global economy have caused global economic activity to become increasingly more interconnected. Cross-border flows including foreign direct investment, loans, equity and debt purchases reached $10.7 trillion annually before the financial crisis, up from less than $1 trillion in 1990. Beyond investment, U.S. trade volume has increased roughly four times its 1992 level. This level of economic activity is supported by a $10 trillion trade finance market and global foreign exchange activity that tops $4 trillion dollars a day, of which over $800 billion involves the U.S. dollar. That is more than a ten-fold increase since 1986.
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Exhibit!2 !

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DAILY US FOREIGN EXCHANGE TURNOVER HAS INCREASED FROM $58 BILLION TO OVER $800 BILLION IN 25 YEARS!
Daily U.S. Foreign Exchange Turnover! 900! 800! 700! Spot trades represent 55 percent of the total while futures have risen from nearly nothing in 1992 to over $100 billion a day in 2010.!

Dollars ($B)!

600! 500! 400! 300! 200! 100! 0! 1985! 1990! 1995! 2000! 2005! 2010!

Source: New York Federal Reserve!

The bottom line is that growing global financial opportunities mean individuals and companies are less tied to their home country. As such, global banks are essential to effectively meeting investment needs. Advocates for breaking up large financial institutions should ask themselves: Will regional banks or banks restrained within U.S. borders compete against their already larger European, Chinese and Japanese competitors? A growing, complex global economy requires global banks. Excellent small banks and Americas regional banks are not equipped to handle financial transactions on this scale and in all corners of the globe. Instead of breaking up banks, lets instead regulate banks in a way that improves safety and soundness by focusing on capital levels (and quality of capital), liquidity and transparency. Tony Fratto is a Managing Partner at Hamilton Place Strategies, former Assistant Secretary at the U.S. Treasury Department, and a former White House official. He is also an on-air contributor for CNBC.

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