Wharton Finance professor Chaojun Wang discusses his research that in part looks at on how banks can become too-big-to-fail.

The global financial meltdown of 2008 prompted a slew of  U. S. rules aimed at reining-in the banking industry to prevent a repeat. Now the U.S. is rolling back some of the Dodd-Frank post-crisis regulation regime. In a wide-lens view of the dynamics at play, Wharton finance professor Chaojun Wang, whose research focuses on how financial markets are organized, explains why some financial markets are so concentrated, which can lead to the problem of too-big-to-fail banks. He spoke to Knowledge at Wharton about his research on these topics.

An edited transcript of the conversation follows.

Knowledge at Wharton: Tell us about the topics that you focus on?

Chaojun Wang: I am interested in the organization of financial markets, how banks and financial institutions trade with each other, whether these organizations are efficient and how regulations impact the financial market structure.

For example, after the 2008 financial crisis, there has been a lot of concern about the risk of having very few too-big-to-fail banks dominating the financial system. I provide one explanation for why trade intermediation is highly concentrated in financial systems on very few large theaters, like Citi and JPMorgan.

On the one hand, there is some efficiency gained if everybody trades with JPMorgan because JPMorgan will be very efficient in balancing its inventory very quickly, handling all of the trading orders from all of the customers. On the other hand, you do want to have more than one dealer because there is a desire from the customers, like insurance companies and mutual funds, to have more competition among the dealers…. These two forces, the inventory efficiency and the inventory balancing, versus the competition among the dealers, will determine the structure of financial systems in such a way that most of the trades will be concentrated among very few large dealers.

This is an explanation for why we have very highly concentrated financial systems. Sometimes it is efficient. Sometimes it is inefficient in the sense that there may be too much concentration or not enough concentration.

Knowledge at Wharton: What are some of the key takeaways for regulators and banks?

Wang: One implication of this model is that if you have very liquid assets, let’s say some high-yield corporate bonds, and there is not much trading demand for the underlying assets, then it is important to have a highly concentrated market because you want to increase the efficiency of inventory balancing. In this case, you want to increase the concentration and, therefore, decrease the numbers of dealers handling the market.

On the other hand, if you have a highly liquid asset, let’s say some treasuries where the inventory balancing is not as big of a concern as for high-yield corporate bonds, then you want to decrease the market concentration because you want to decrease the market power of all of the large dealers, therefore increasing the volume of trade.

The post-crisis financial regulations, such as the Volcker Rule and capital requirements, certainly have a benefit for the financial system by increasing the financial stability. But if there is a more tailored version of these financial regulations targeting different asset classes, it would be more helpful towards mitigating concern about liquidity by market participants.

Knowledge at Wharton: What could regulators do to tailor that better? It sounds like you’re saying it’s not so bad to have a few too-big-to-fail banks. But there is lingering concern among the government, the banking industry and consumers that if another financial crisis happens, we will be in trouble by having power concentrated in these institutions.

Wang: The original intention of all of these financial regulations was to increase financial stability by requiring the banks to have a larger capital buffer in case of a crisis. These are certainly helpful to mitigate the risk of any crisis. What my theory predicts is that you want to have lower capital requirements because you want to encourage dealer participation for the highly liquid assets such as treasuries, you don’t want to have a very large, monopolist bank that dominates a huge market like the treasuries market.

On the other hand, if you have a liquid, relatively small asset that you are trading, then concentration is actually beneficial so that you can increase the capital requirements for those assets. At the same time, those liquid assets are more risky. So, it would have been in line with the initial intention of the regulators to reduce the risk of the trading for these assets.

Knowledge at Wharton: What’s next for your research?

Wang: I’m always interested in research in the design and structure of financial market systems. In my view, this is a very exciting area at this moment, especially after the financial crisis where people are thinking about redesigning the rules by which financial institutions have to follow when they trade with each other. I’m very excited to do more research in this area.