Financial Fragility and Malaysian Banking Consolidation

I was reading this post on Free Exchange yesterday, and one of the comments (by Don the libertarian Democrat) was interesting and thought provoking. He relates an anecdote (from Andrew Haldane via Martin Wolf) that's worth repeating in full:

"No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they
would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight. All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did banks not understand that the official sector would not underwrite banks mismanaging their risks? Yet history now tells us that the unnamed banker was spot-on. His was a brilliat articulation of the internal and external incentive problem within banks. When the big one came, his bonus went and the government duly rode to the rescue. The timeconsistency [sic] problem, and its associated negative consequences for risk management, was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities."

This nicely illustrates some of the main problems with the banking system as it stands today - the incentive structure promotes a blindness towards risk, a prevalence of moral hazard, and the principal-agent problem. Don then goes on to mention that Shelia Blair, Chair of the U.S. Federal Deposit Insurance Corporation (FDIC), remarked that maybe big banks ought to be outlawed. This struck a resonant chord with me, as I worked in a bank through the worst days of the 1997-98 crisis and its aftermath.

Financial sector consolidation in Malaysia has its advantages, such as stronger balance sheets capable of handling shocks, having the scale to compete on a regional and global basis, and making the best use of scarce managerial talent - I don't think there is any argument that some of our banks were very badly run leading up to the crisis. On the other hand, it is not obvious to me why those banks could not have been allowed to fail, especially as few were large enough to pose real systemic risks. Nor is it obvious that well-run small banks such as Wah Tat should be 'punished' by being forced into a merger. Some of these banks functioned as "community" banks, with a strong presence in their respective markets and a localised knowledge of their customers. Subsuming these banks into a national level bank doesn't strike me as necessasrily increasing the efficiency and efficacy of financial intermediation on the ground. If my memory serves correctly, managerial x-efficiency in banks also peaks at about USD10 billion in assets (this was back in the 1990s), which means profitability falls off at larger sizes i.e. shareholders aren't necessarily getting a good deal either.

More to the point, I think by consolidating the domestic financial instutions into ten big groups, we have probably increased the fragility of the Malaysian financial sector - a failure in any one of these banking groups will pose a risk to the rest of the banking system. First the likelihood of moral hazard being a problem is increased as bank size increases. Second, the principal-agent problem is exacerbated, particularly with the rules on maximum shareholding. While we don't want a Malaysian R. Allen Stanford, insisting on hands-off shareholders divorces management interests from shareholders'. Third, institutional shareholders are probably more likely to pressure bank management on returns, which contributes to the incentive problem described in the quote above.

Note that the US situation right now is indicative of the problems I've described above - it's the big money center banks that are causing systemic problems. The smaller state and regional banks are either failing or doing fine; they just don't make the headlines (and there are an awful lot of them). As long as depositers aren't losing their money (which is where the FDIC comes in), individual bank failures won't trigger a general bank run and a failure of the system.

While I don't think we will have a near term problem in the Malaysian banking system with respect to egregarious risk-taking - too many bank managers still bear the scars and memories of 1997-98 - the next generation of bank managers is another matter. It's easier to do something about it now when the system is relatively stable, then trying to reform the system on the fly in a crisis. I don't know if regulatory limits on bank size is at all possible or desirable, and I'll admit that I have no concrete solutions on hand to suggest (how about unlimited shareholder liability?). But this question does bear thinking about and discussing, as part of the larger debate on global financial sector reform.

Since any post of mine won't be complete without a statistic or two: the US has approximately one commercial bank for every 40k in population. The corresponding ratio for Malaysia is about 690k (including all the new Islamic bank subsidiaries, as well as foreign banks), and 1,230k (including foreign banks only). If we're talking about just the 10 domestic banking groups, the number jumps to 2,700k.