When Bigger Isn't Better

Diseconomies of scale and scope. If that bit of economists' jargon is unfamiliar to you, you are not alone. It means that some companies are so big (have such grand scale) that they are less efficient than smaller rivals, and so diversified (have such a wide scope of activities), that they are beyond the ability of ordinary mortals to manage. This phrase hasn't been much used in past decades. After all, bigger seemed better, and the products of MBA programs thought themselves capable of managing such a wide variety of businesses that knowledge of the nuts and bolts of any one of them seemed a waste of space in the executive brain. Surely, these companies were benefiting from economies of scale and scope--costs that decline the bigger and more diversified they get.

Well, not surely. We have learned from this crisis that there is a point at which bigger is worse, and diversification increases rather than decreases enterprise risk. A banker might be good at schmoozing customers on a golf course, but not exactly at the top of his game when it comes to understanding the complicated equations being used by the bright young things in his risk management department.

AIG was a well managed and profitable insurance company before it decided to become a diversified financial operation, "quants" taking on risks that the company's executives did not understand and therefore could not manage. Several of the commercial banks now forced to go hat-in-hand to governments for bailouts were nice, profitable institutions when they stuck to taking deposits and making loans to borrowers they either knew personally or had reason to believe could actually repay the loans.

As these firms became grander, their managers more confident of their ability to run these behemoths, they became too big and too interconnected to be allowed to fail, at least in the view of politicians who see the financial system as a row of dominoes, a house of cards, a fragile network in which any one major player can bring down all the others, and the real economy as well. Bankers, faced with insolvency, found these fears worth playing on as they inserted their snouts into the bail-out trough.

What they hadn't reckoned with was the quite sensible public reaction: if the effect of the failure of these firms is not confined to their shareholders and employees, but can bring down the economy, surely they are like electric companies and other utilities, and should be regulated as such. Told to lend more to some applicants, less to others; not to dare to seize assets of borrowers (read, voters) in default; not to pay staff more than a risk-averse congressman from a safe seat (say, Barney Frank, the 28-year veteran and Democratic chairman of the House Financial Services Committee) deems proper.

Consider the case of Lehman Brothers. Then-Treasury Secretary Hank Paulson, upset that his bail-out of Bear Stearns was being said to have unleashed a dreaded case of moral hazard on the private sector, decided that Lehman Brothers should be allowed to go under. He did and it did. The result was a disaster for the so-called counter-parties--institutions that traded with Lehman had $582 billion of their assets frozen while the administrators sorted out the mess. Not everyone is a loser: the lawyers and accountants sorting out the European end of the company's affairs have run up bills of over $100 million in six months, and the meters are ticking at rates of £620 per hour for senior accountants and higher still for top lawyers.

We will never know if the counter-parties and other bystanders to the Lehman crash would have taken steps to minimize their losses if Paulson & Co. had not bailed out Bear Sterns, creating the moral hazard his critics feared. But we do know a few things.

The first is that if a big financial institution were to go down, there is enough risk of collateral damage to prompt government to intervene lest credit dry up and innocent bystanders pay a huge price in lost incomes, jobs and homes. The second is best put by Carnegie Mellon Professor Allan Meltzer, America's leading student of the banking system: "If a bank is too big to fail, it is too big." The third is that those in management control of banks do not understand the risks being created for them by the modelers and other practitioners of arts invented long after many senior bankers began to concentrate on climbing the corporate ladder rather than brushing up on higher math.