A New Outcome For "Too Big To Fail"

With the number of banks in the US steadily falling over the last few decades, sector consolidation into a handful of larger institutions has raised concerns about economic implications for the United States.

It may also be the harbinger of a potentially larger threat - an easy implementation of central bank digital currencies (CBDCs). Bank sector consolidation allows for a more straightforward implementation of CBDCs and greater surveillance and control over financial transactions.

The Federal Deposit Insurance Corporation (FDIC) has already warned against the shrinking number of banks, which is partly due to deregulation and allowing banks to operate outside state lines. Mergers, acquisitions, and failures, like Silicon Valley Bank and First Republic Bank, have also contributed to a 71% decline in the overall number of banks operating in the US over the last four decades.

The Government Accountability Office published preliminary findings indicating these events transpired due to weak risk management practices and risky business strategies. Elinda Kiss, a Professor at the University of Maryland, who is considered a leader in research in banking regulations, expects the number to shrink even further.

“Yes, I think we will see more consolidation,” Kiss said. “I don’t have an idea what the perfect number of banks is.”

Banks Collapse

The 2010 Dodd-Frank Financial Reform and Consumer Protection Act was meant to prevent a repeat of the Global Financial Crisis, but recent events have raised concerns about its efficacy. Three of the four largest bank collapses in U.S. history occurred in 2023, accounting for 2.4% of all assets under management in the banking sector.

Eventually the FDIC took over Silicon Valley Bank, First Republic Bank, and Signature Bank, acting as an intermediary in asset sales, guaranteeing the deposits, and providing daily U.S. dollar swap agreements to prevent the crisis from escalating globally.

Like in 2008, the government turned to the country’s largest institutions, like JP Morgan ($JPM), to take over the collapsed banks operations.

According to Federal Reserve economist Vitaly M. Bord's research, sector consolidations ultimately lead to decreased market competition. Reduced consumer choices lead to higher costs and erosion of the bargaining power of consumers, diminishing their satisfaction and trust.

Market Competition

Recently, the largest operators like Bank of America ($BAC) have been domestically expanding, despite over 80% of their revenues coming from that market. Since 2019, BAC has set its sights on Ohio, Minnesota, and Colorado, threatening smaller niche banks.

FDIC’s 2020 Community Banking Study shows these niche banks play a vital role in the functioning of the U.S. financial system. Smaller local banks often have a deeper understanding of their communities and play a crucial role in supporting local businesses and economic growth.

Previous FED research also shows that consolidation may lead to the closure of branches in rural areas or underserved communities, leaving them with limited access to essential banking services. This development can exacerbate economic inequality and hinder the development of small businesses and entrepreneurship.

Citizens’ Freedoms

It is also raising concerns about the U.S. government’s ability to monitor financial transactions. CBDCs are digital currency issued by central banks and linked to the issuing country’s official currency. In many ways, they’re similar to stablecoin cryptocurrencies but not decentralized. Instead, they’re state issued and operated.

In March, Governor Ron DeSantis announced preemptive legislation to protect citizens of Florida from CBDCs - prohibiting the use of a federally adopted Central Bank Digital Currency.

“The Biden administration’s efforts to inject a Centralized Bank Digital Currency is about surveillance and control,” said Governor DeSantis. “Florida will not side with economic central planners; we will not adopt policies that threaten personal economic freedom and security.”

Although Biden issued an executive order calling for urgent research and development of CBDC, Federal Reserve Chairman Jerome Powell showed a reserved stance regarding the subject. Speaking before the House Financial Services Committee in March, Powell noted that the “digital dollar” is not yet in the clear.

“What we’re doing is experimenting in kind of early stage experimentation. How would this work? Does it work? What’s the best technology? What’s the most efficient?” he said, adding that creating a CBDC meant for the broader public would require the authorization of Congress, but one meant exclusively for use between banks would not require that approval.

Dystopian Future

John Butler, Investment Director at SouthBank Investment Research, has also warned that CBDCs give too much power to central banks. This could threaten citizens' freedoms, giving unprecedented insight into their privacy or straight out freezing their assets.

It could lead to dystopian scenarios where CBDCs are weaponized against political dissidents or used to socially engineer the population, Butler said in an interview with Kitco News. “It becomes a very frightening proposition to hand over any and all financial privacy to some central organization,” he said.

To protect against such perils, he recommends holding precious metals like gold and silver.

“Gold actually becomes materially more attractive as a store of value in a low or zero rate world, one that CBDCs would find it easy to implement,” Butler noted, adding that those who have to be invested in the equities market should opt for dividend income.

Negative Rates

Beyond the issue of government control, CBDCs may also lead to broader negative interest rates.

With the abolition of paper currencies, paying negative interest rates on electronic liabilities becomes easy to implement. While the introduction of CBDCs and negative interest rates marks a pivotal point in the history of central banking, it raises concerns about other economic implications.

Professor Pengfei Jia from Nanjing University explored this topic in a paper titled “Negative Interest Rates on Central Bank Digital Currency.” In his research, Prof. Jia argues that paying negative interest on CBDC induces less saving and higher consumption, with lower savings causing a fall in capital investment and supply-driven inflation.

Including positive-yielding government bonds in the model would negate these effects, as capital flows into those assets due to “flight to quality,” according to Prof. Jia. His research shows that implementing negative interest rate payments on CBDCs can boost consumption and may induce inflation at the cost of causing a fall in capital investment and output, according to his research.

For the FED’s Powell, he remains undecided about the pros and cons of CBDCs.

"I am legitimately undecided on whether the benefits outweigh the costs or vice versa," Powell said during a hearing before the Senate Banking Committee in July 2021. Since then, he hasn’t changed his stance, but it is likely that CBDCs will remain a lingering topic at the FED for the foreseeable future.