Too Big to Fail, Economies of Scale, Cities, and Companies

I've been reading research on organizational size and performance as it is pertinent to the book that Huggy Rao and I are writing on scaling-up excellence.  In doing so, I also have been following the debate about banks and whether the assertion that both a cause of the meltdown and a risk for future fiascoes is that banks are "too big to fail."   Of course, the debate is hard to sift through because there is so much ideology and so many perverse incentives (example: the bigger the bank, the more the CEO, top team, and board will -- in general -- be compensated). 

Although bankers have been generally silent on this, some have started speaking-up since former Citigroup CEO Sandy Weil -- the creator of that huge bank (which lives on courtesy of the U.S. taxpayers) -- joined the chorus and argued that big banks ought to be broken-up.   Simon Johnson -- an MIT professor -- had an interesting editorial in the New York Times yesterday where he reviews some of the recent arguments by bankers and lobbying groups that very big banks are still a good idea -- and refutes their arguments (and points out that both Democrats and more recently Republicans are starting to challenge the wisdom of mega-banks). 

I especially want to focus on the "economies of scale argument," that there are more efficiencies and other advantages enjoyed by larger systems in comparison to smaller ones. This appears to be the crux of an editorial in defense of large banks published in the NYT on August 22nd by former banking executive William B. Harrison Jr.   I was struck by one of Johnson's retorts:

As I made clear in a point-by-point rebuttal of Mr. Harrison’s Op-Ed commentary, his defense of the big banks is not based on any evidence. He primarily makes assertions about economies of scale in banking, but no one can find such efficiency enhancements for banks with more than $100 billion in total assets – and our largest banks have balance sheets, properly measured, that approach $4 trillion.

Although I am interested in -- and an advocate -- of the power of growing bigger and better organizations at times, doing so is only justifiable in my view if excellence can at least be sustained and preferably enhanced, and the side-effects and risks to do not overwhelm the benefits.  Unfortunately, the optimism among the bigger is better crowd often outruns the facts.  For starters, I would love to see sound evidence that really really big organizations enjoy economies of scale and other performance advantages -- Wal-Mart might be such a case, they certainly have market power, the ability to bring down prices, and brand recognition  -- but I can't find much systematic evidence for economies of scale across really big organizations.  If Mr. Harrison is correct, for example, there isn't any evidence of increased efficiencies for banks over 100 billion in assets.

This debate reminds me of some fascinating research on the differences between cities and companies. Luis Bettencourt and Geoffery West of the Santa Fe Institute present fascinating evidence that larger cities are more efficient and effective than smaller ones.  As they conclude in this article in Nature:

Three main characteristics vary systematically with population. One, the space required per capita shrinks, thanks to denser settlement and a more intense use of infrastructure. Two, the pace of all socioeconomic activity accelerates, leading to higher productivity. And three, economic and social activities diversify and become more interdependent, resulting in new forms of economic specialization and cultural expression. We have recently shown that these general trends can be expressed as simple mathematical ‘laws’. For example, doubling the population of any city requires only about an 85% increase in infrastructure, whether that be total road surface, length of electrical cables, water pipes or number of petrol stations.

OK, so it seems that economies of scale do exist for at least one kind of social system, cities.  Does this provide hope for those bankers?  Apparently not. Check out West's Ted Talk on "The Surprising Math Cities and Corporations."  He concludes several interesting things about scaling. First, the bigger the biological system, the more efficient it becomes. Second, following the above quote and the logic that follows from organisms, cities become more efficient (and creative and financially successful too) as they become larger.  Third, that cities rarely die, but organizations almost always do (he claims always).  Fourth, he shows that companies do scale -- in fact he talks about Wal-Mart, shows their economies of scale,  and describes his dataset of 23,000 companies. But the twist is that as companies become larger and older they become weighted down with bureaucracy and -- unlike cities -- the resulting internal friction both outweighs the benefits of economies of scale and renders them unable to to pull-off the radical innovations required to stay alive. 

Here is this conclusion in more detail, from an article in The New York Times:

This raises the obvious question: Why are corporations so fleeting? After buying data on more than 23,000 publicly traded companies, Bettencourt and West discovered that corporate productivity, unlike urban productivity, was entirely sublinear. As the number of employees grows, the amount of profit per employee shrinks. West gets giddy when he shows me the linear regression charts. “Look at this bloody plot,” he says. “It’s ridiculous how well the points line up.” The graph reflects the bleak reality of corporate growth, in which efficiencies of scale are almost always outweighed by the burdens of bureaucracy. “When a company starts out, it’s all about the new idea,” West says. “And then, if the company gets lucky, the idea takes off. Everybody is happy and rich. But then management starts worrying about the bottom line, and so all these people are hired to keep track of the paper clips. This is the beginning of the end.”

The danger, West says, is that the inevitable decline in profit per employee makes large companies increasingly vulnerable to market volatility. Since the company now has to support an expensive staff — overhead costs increase with size — even a minor disturbance can lead to significant losses. As West puts it, “Companies are killed by their need to keep on getting bigger.”

There are still advantages to size despite these rather discouraging data: market power, legitimacy, the ability to do complex things that require multiple disciplines, and brand recognition come to mind.   And there are studies by economists that show economies of scale help under some conditions.  Some organizations are also better than others at limiting the burdens of bureaucracy as they grow-- Wal-Mart is one of them. 

As a practical matter, when I think of Bettencourt and West's data and combine it with Ben Horowitz's amazing post on scaling, it appears his advice to "give ground grudgingly," to add as little structure and process as you can get away with given your organization's size and complexity, is even more sound than I originally thought.

As with many researchers, West has a healthy ego and states his findings with more certainty than is probably warranted.  But these are -- unlike the bankers -- evidence-based statements, and when I combine them with what Huggy and I are learning about how hard scaling is to do well (there are big differences between companies that do it well versus badly), the lack of evidence for economies of scale in really big banks, and a system where the primary defenders of really big banks have strong incentives and weak evidence to support their positions, I am hoping that in a political season where my country seems hopelessly split on so many issues, perhaps this is one where both sides can come together and hold an evidence-based position.

Comments

[Account Deleted]

"Too big to fail" is a colloquial term in describing certain financial institutions which are so large and so interconnected that their failure will be disastrous to the ...

Don,
http://yesshop.yolasite.com/blog.php

[Greg]

"...all these people are hired to keep track of the paper clips."

This is the end of the organization NOT because of the cost of hiring paper-clip-counters, but because this is the surest sign that the company is unable to attract and hire trustworthy people of sound judgment (or treat trustworthy people like trustworthy people).

I am amazed at companies that will let an employee use a $500k piece of equipment, but can not trust this person to make a $20 purchase.

[Anne Miller]

I wonder about the way that the statement that "cities scale" is evaluated. Does it take into account quality of life, stress and crime statistics? I would argue that just because "cities scale" by a limited set of measures doesn't mean that they scale when you consider an extended set of measures. So, given that I am not sure that "cities scale" it would be interesting to me to hear what others think about drawing a parallel between "bigger is better" for not only cities and companies... but education and government bureaucracy also.

[David Grover]

I think the emphasis on "counting paperclips" is a misdirection. That happens, for sure, and I've worked in companies where the financial bureaucracy overwhelms operational efficiency.

But I think there's a lot to be said for purely socio-cultural ossification, as well. Companies where the average tenure is long may be loath to solve problems at the department or unit level because groupthink has convinced them the problems are hugely complex, and so their efficiency just degrades over time. New employees join and may push against this culture, but they either succeed, are assimilated or excluded, and in my experience the latter two are more probable than the former.

I personally spend a lot of time refactoring dinosaur data management systems, so I see this all the time. But its extremely common at companies older than about ten years, and much more virulent in companies where the average tenure is very long.

[Mark Johnson-Lewis]

Wondering if you're also looking at the nonprofit field - in particular as there is lots of talk about "scaling" what works. e.g., everyone wanted to "scale" the Harlem Children's Zone, etc. And I am a survivor of a nonprofit that was on an unsustainable track of growth, in that growth was the only way to survive. I think there's lessons to learn on both sides, although the dynamics are different (profit motive, vs. social change, etc.).

[pscoop]

OK this is a tangent but it's clear there is an economy of scale *for the city*, i.e. a doubled population requires on 85% increase in infrastructure, but results in significant increase in land/rent which in turn would raise salaries.

An aspect of a cities economy of scale is geographical. San Jose doesn't scale by acquiring Eugune, Newcastle, Lyon, and Johannesburg. "space required per capita shrinks, thanks to denser settlement and a more intense use of infrastructure" happens because cities are constrained geographically (or sometimes by artificial geography of greenbelts, zoning, etc), however corporations tend to grow by moving to bigger offices, creating new offices, or acquiring new companies. These things are typically the catalyst for structure and process which in the end bogs down even the best companies.

[Larry]

You may well have already thought of this. It would seem that evolutionary biology has some useful perspective on scaling up excellence. I might describe the theory of evolution as a cybernetic model for evidence-based change, including the right size for any organic system in a given environment. In the case of really big banks, certain components or subsystems (e.g., the CEO, the board)of the larger organic system that is the bank act counter to the long term welfare of the larger system. Oh, and I would have thought that corporations are biological systems as well.