By George Washington of Washington’s Blog.

As everyone knows, the big banks have gotten bigger and bigger. Noted economist Mark Zandi says we have an oligopoly of banks, and that “the oligopoly has tightened”.

The TARP Inspector – Neil Barofsky – told Huffington Post yesterday that, because of the consolidation in the banking industry:

I think we may be in a far more dangerous place today than we were a year ago.

WHY IS CONCENTRATION DANGEROUS?

Economists and other financial experts could provide many reasons why concentration is dangerous. Certainly, their very size distorts the markets and limits the growth of smaller banks. and the economy cannot fundamentally recover while the giants continue to drag our economy down the drain.

But I would like to use an analogy from science to discuss why our current, highly-concentrated banking lineup presents a huge threat to our economy (analogies can sometimes be useful; e.g. Taleb talks about black swans).

It has been accepted science for decades that when all the farmers in a certain region grow the same strain of the same crop – called “monoculture” – the crops become much more susceptible.

Why?

Because any bug (insect or germ) which happens to like that particular strain could take out the whole crop on pretty much all of the region’s farms.

For example, one type of grasshopper – called “differential grasshoppers” – loves corn. If everyone grows the same strain of corn in a town in the Midwest, and differential grasshoppers are anywhere nearby, they may come and wipe out the entire town’s crops (that’s why monoculture crops require such high levels of pesticides).

On the other hand, if farmers grow a lot of different types of crops (“polyculture”) , then a pest might get some crops, but the rest will survive.

I believe that the same principle applies to our financial system.

If power and deposits are concentrated in a handful of mega-banks, problems with those banks could bring down the whole system. As Zandi noted, there is an oligopoly in the banking industry (and “the oligopoly has tightened”).

Moreover, the mega-banks are huge holders of derivatives, including credit default swaps. JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives.

Even though JP, B of A, Goldman and Citi are separate corporations, they are so interlinked and intertwined through their derivatives holdings that an attack by a “pest” which swarmed in on their derivatives could take down this “monoculture” of overly-leveraged, securitized, derivatives-heavy banking.

Indeed, taking just one example – JP Morgan – independent analyst Reggie Middleton notes:

As of June 30, 2009, JPM had exposure of $85 billion (or 108% of its tangible equity) towards off balance sheet lending commitments and guarantees… As of June 30, 2009, the total notional amount of derivative contracts outstanding as of June 30, 2009 was about $80 trillion (or 101,846% of its tangible equity)… Gross fair value (before FIN 39) of the derivative receivables and derivative payables was $1,798 billion (or 2,276% of its tangible equity) and $1,749 billion (or 2,214% of its tangible equity), respectively. The, fair value of JPM’s derivative receivables (after FIN 39) was $84 billion (or 106% of its tangible equity) while the fair value of JPM’s derivative payables (after FIN 39) was $58 billion (or 73% of its tangible equity). FIN 39 allows netting of derivative receivables and derivative payables and the related cash collateral received and paid when a legally enforceable master netting agreement exists between JPM and a derivative counterparty… About 23% of the derivative receivables (in terms of fair value after FIN 39) were below investment grade (less than BBB or equivalent) while 12% were rated BBB or equivalent… Within the dealer/client business, JPM utilizes credit derivatives by buying and selling credit protection, predominantly on corporate debt obligations, in response to client demand for credit risk protection on the underlying reference instruments. Protection may be bought or sold by the Firm on single reference debt instruments (“single-name” credit derivatives), portfolios of referenced instruments (“portfolio” credit derivatives) or quoted indices (“indexed” credit derivatives). The risk positions are largely matched as the Firm’s exposure to a given reference entity under a contract to sell protection to a counterparty may be offset partially, or entirely, with a contract to purchase protection from another counterparty on the same underlying instrument. Any residual default exposure and spread risk is actively managed by the Firm’s various trading desks. After netting the notional amount of purchased credit derivatives where the underlying reference instrument is identical to the reference instrument on which the Firm has sold credit protection, JPM has net protection purchased of $82 billion along with other protection purchased of $77 billion. So that’s it. They are square, then. Of course unless the sellers of their protection default. If they do, then it may very well cause a daisy chain reaction that could get very ugly … If you thought Lehman caused problems, compare Lehman’s counterparty exposure to JPM’s.

The bottom line is that our current banking monoculture threatens not only the biggest banks, but the entire financial system. Pesticides become less effective as pests develop resistance – and, as a byproduct, we poison friendly critters. Likewise, the giants “creatively” work their way around regulations so that the regulations are no longer effective (or at least not enforced, and regulatory capture is widespread. And too much regulation stifles productivity,as an unintended byproduct.

Having power and deposits spread out among more, smaller banks would greatly increase the stability of the financial system. And having more power and deposits in banks using a wider variety of business models (e.g. among banks that aren’t heavily invested in derivatives and securitized assets) will create a banking “polyculture” which will lead to a much more stable financial system.

In other words, if we decentralize power and deposits and increase the variety of banking models, we will have a healthier financial system, we won’t have such an urgent need to try to micromanage every aspect of the banking system through regulation,and the regulations we do have will be more effective.

By the way, I would argue that that is one of the reasons why Glass-Steagall was so important: it enforced diversity – depository institutions on the one hand, and investment banks on the other. When Glass-Steagall was revoked and the giants started doing both types of banking, it was like a single crop cannibalizing another crop and becoming a new super-organism. Instead of having diversity, you’ve now got a monoculture of the new super-crop, suscecptible to being wiped out by a pest.

The kinds of things which threaten depository institutions are not necessarily the same type of things which threaten investment banks, hedge funds, etc.

The above is yet another reason we should break up the giant banks using antitrust or other laws.

Note: Wells Fargo’s derivatives holdings are substantial, but much less than the other big boys. But rumors are that Wells might be in real trouble as well due to its commercial real estate and other portfolios.