Thoughts of the Week - Big Bank Inefficiencies

Here is a recent article by Zerohedge on big bank inefficiencies.

I usually try not to cite ZH, but this has a lot of good links. It reminds me of an HBS article I read recently about bees and risk management. The tendencies of bees towards decentralization is a risk management tool to prevent TBTF.

Take, for example, their approach toward the "too-big-to-fail" risk our financial sector famously took on. Honeybees have a failsafe preventive for that. It's: "Don't get too big." Hives grow through successive divestures or spin-offs: They swarm. When a colony gets too large, it becomes operationally unwieldy and grossly inefficient and the hive splits. Eventually, risk is spread across many hives and revenue sources in contrast to relying on one big, vulnerable "super-hive" for sustenance.

In fact, when hives divide, it is the old queen who departs, leaving the old hive to a young virgin queen. Contrast this with normal corporate M&A and spin-off behavior in which risk remains concentrated.

One classic argument in favor of TBTF is that big banks are in a better position to capitalize on economies of scale, and the fact that breaking up large banks simply doesn't prevent bank runs. The ZH article attacks the first point through a discussion of diseconomies of scale (which I quoted almost verbatim from here):

1. atmospheric consequences due to specialization - as firms expand there will be increased specialisation, but also less commitment on the part of employees. In such firms, the employees often have a hard time understanding the purpose of corporate activities, as well as the small contribution each of them makes to the whole. Thus, alienation is more likely to occur in large firms.
2. bureaucratic insularity - as firms increase in size, senior managers are less accountable to the lower ranks of the organisation and to shareholders. They thus become insulated from reality and will, given opportunism, strive to maximise their personal benefits rather than overall corporate performance. This problem is most acute in organisations with well-established procedures and rules and in which management is well-entrenched.
3. incentive limits of the employment relation - the structure of incentives large firms offer employees is limited by a number of factors. First, large bonus payments may threaten senior managers. Second, performance-related bonuses may encourage less-than-optimal employee behavior in large firms. Therefore, large firms tend to base incentives on tenure and position rather than on merit. Such limitations may specially affect executive positions and product development functions, putting large firms at a disadvantage when compared with smaller enterprises in which employees are often given a direct stake in the success of the firm through bonuses, share participation, and stock options.
4. communication distortion due to bounded rationality - Because a single manager has cognitive limits and cannot understand every aspect of a complex organisation, it is impossible to expand a firm without adding hierarchical layers. Information passed between layers inevitably becomes distorted. This reduces the ability of high-level executives to make decisions based on facts and negatively impacts their ability to strategize and respond directly to the market. Even under static conditions (no uncertainty) there is a loss of control.

The Alternative Banking working group of OWS (Occupy Wall Street) prefers TIBACO to TBTF. It stands for Too Interconnected, Big and Complex to Oversee, which I think is a more apt description of what exactly is wrong with these banks.

Things I am up to:

- I recently downloaded Anki, a flashcard program, to help me study for the CFA (Chartered Financial Analyst) exam. I've always wanted to try Anki, but I never got around to it. It displays flashcards on increasing time intervals based on the principle of spaced repetition. One example of this is the following image, where successive "boxes" show their cards less frequently, e.g. the flashcard program will draw from box 1 half of the time, box 2 one quarter of the time, etc.

- Learning R. There is a lot of vibrant community support (especially in finance) for R. Some of my favorite quant finance bloggers - Timely Portfolio, Systematic Investor, Milktrader, CSS Analytics - use R. Non-finance R bloggers can be found on the excellent R-bloggers. So far, I have already been able to link my R environment to Bloomberg terminal data as well as free data sources such as Yahoo Finance and FRED (Federal Reserve Economic Data) using community packages.

Books I would buy my friend if he had my exact interests and his birthday were coming up very soon (say, in 3 days):

Haidt, Jonathan - The Happiness Hypothesis
Koo, Richard - The Holy Grail of Macroeconomics
Postman, Neil - Amusing Ourselves to Death
Schelling, Thomas - Micromotives and Macrobehavior
Singer, Peter - Animal Liberation
Strausse, William & Howe, Neil - Generations
Wolfram, Stephen - A New Kind of Science