On 12 October 2009, the Nobel committee announced its annual Prize for Economics, awarding it to Oliver E. Williamson and Elinor Ostrom (incidentally the first female winner of this prestigious award). The committee awarded these two economists the prize for their independent work on 'economic governance' and 'cooperation in organizations'.
Is the timing interesting or what?
Just as politicians and regulators are starting to think about how to rein in large banks in the light of the disaster of the Global Finance Crisis (GFC), the Nobel committee highlights the work of economists working in a highly relevant area, the problems of managing firm size.
In an earlier blog, I suggested that the world's largest 'universal banks' (or 'financial supermarkets') may have become just 'Too Big to Succeed' and suggested that politicians and regulators may have to force firms to grow smaller and/or increase 'corporate governance'. There is ample evidence from case studies, such as UBS, AIG and RBS, that 'top decision makers' at today's banking behemoths really do appear to be 'operating in purely imaginary worlds'.
I am not an economist and usually tend to agree to disagree with members of the 'dismal science'. But Williamson is not a typical economist, and his training and research includes not only economics but also business administration and management. He works far from the ivory towers that other economists appear to inhabit.
Williamson's work is vast but one of his major contributions is in the area of 'transaction costs'. In its very simplest form, Williamson argues that firms organize themselves to minimize transaction costs but in doing so 'information asymmetries' are created which at a certain size, or complexity, become counterproductive. Increasing hierarchies and so-called 'information impactedness' [crudely you don't know what you don't know] make it difficult and expensive for managers and shareholders to know what exactly is going on. For example, the not inconsiderable costs of creating a risk management infrastructure could be seen as a cost to reduce informational problems, thereby reducing the savings from reducing transaction costs.
One of Williamson's arguments is that the asymmetry of information in a large organization creates 'moral hazard' in that employees will begin to use 'inside' information opportunistically for their own benefit rather than the firm's. Does this sound familiar - rogue trader?
The implication of Williamson's insights is that there is a "law of diminishing returns" to firm size and that after a certain size, or level of complexity, large firms cease to be efficient.
The question of course is 'how big is too big?'
In a prior blog, I suggested that there were two possible actions if a firm was found to be 'too big to succeed': (a) break up the firm or (b) increase corporate governance. But, of course, they are other alternatives and combinations of actions.
In the absence of any feeling for the maximum, or even optimal, size of a financial institution, regulators could consider requiring firms to maintain additional capital based on the number, size and complexity of the transactions that they undertake. One could think of this approach as a sort of internal 'Tobin Tax' that could be used to build up the 'counter cyclical' capital buffers so beloved of global regulators.
If a future Nobel Laureate were looking for a source of data to test a new theory on the 'optimal size' of financial firms, the Australian banking system would provide a great experimental laboratory.
One of the reasons that have been put forward for why Australia has appeared to dodge the GFC bullet is that it has a pretty idiosyncratic banking system based on the so-called 'Four Pillars'. By law, the 4 largest banks cannot be acquired or acquire one another. At first glance, such a concept may appear perverse and certainly is far from efficient (economically) but maybe each of these banks (which incidentally are roughly the same size) has reached a size that can actually be managed successfully? Could it be that Australia has hit upon the secret of the optimal firm size by accident?
When supervising banks, regulators could do well to pay heed to Williamson, 'Parsimony being a virtue, complication must be justified'.
