The long decline of Los Angeles’ banking sector — and its harmful aftermath

Los Angeles is an economic juggernaut. By some estimates, it is the third largest metropolitan economy in the world, behind only New York City and Tokyo. At $1 trillion in annual output (including the Inland Empire), Greater Los Angeles’s economy is roughly the same size as a Mexico or Indonesia. However, Los Angeles perpetually ranks low as a financial center. In the latest Global Financial Centers Index, Los Angeles came in 29th place, below Calgary, Canada and just barely above cities like Dalian, China and Casablanca, Morocco. This has serious implications for the region’s competitiveness and long-term ability support economic growth and improve incomes. Why is LA’s financial sector so mediocre?

There is one significant contributing factor: there are no major banks based in the region. On the Federal Reserve’s ranking of largest U.S. banks, the LA region’s highest entry (excluding ongoing M&A situations), is Pasadena-based East West Bank in the 43rd spot. East West Bank has $33 billion in total assets, compared to over $1.5 trillion in domestic assets each for J.P. Morgan, Wells Fargo, and Bank of America. One reason for this disparity is clear. Over the past few decades, Southern California has lost most of its major banks to other regions through mergers and acquisitions. Notable examples include:

• 1992 — Security Pacific sold to BankAmerica (San Francisco). At the time, this was one of the largest bank acquisitions in US history.
• 1996 — First Interstate Bancorp sold to Wells Fargo (San Francisco)
• 1998 — California Federal Bank sold to First Nationwide Bank (San Francisco)
• 2015 — OneWest Bank sold to CIT Group (New Jersey)
• 2015 — City National Bank sold to Royal Bank of Canada (Toronto)

Los Angeles’s investment banking industry underwent a similar contraction process after the failure of Drexel Burnham Lambert. Drexel alumni went on to found an important set of private equity firms in the region, including Apollo, Ares, and Leonard Green, but have not been able to build an investment banking presence with the same clout of Drexel’s Beverly Hills powerhouse under Michael Milken. In 2007, when Drexel alumnus Ken Moelis left UBS to launch his own firm with a handful of UBS’s top investment bankers, the newly formed Moelis & Company chose New York as its headquarters despite the fact that Moelis himself and many of his top staff were based out of Los Angeles.

Commercial banks were replaced in Los Angeles by a wide range of alternative lenders, particularly in the real estate space (Countrywide Financial being the most notorious example). More recently, a crop of tech-enabled lenders has appeared, again notably in real estate (e.g. PeerStreet, Patch of Land, AssetAvenue, and RealtyMogul). These are important businesses, both for LA’s finance and technology sectors, but they are unlikely to attain the same levels of influence and reach as large, industry-agnostic banking institutions.

As early as 1996, the New York Times was questioning the state of Los Angeles’ banking sector, asking if Los Angeles needed a financial powerhouse. At the time, they surmised that the loss of major banks was reflective of larger shifts happening in LA’s economy:

“The business landscape of greater Los Angeles has moved from a centralized economy dominated by big companies like aerospace manufacturers — and banks — toward a highly dispersed economy propelled by small businesses, many in entertainment and the electronic media.”

Certainly, LA’s economy underwent a dramatic transition at the end of the Cold War, as massive reductions in federal spending led to the contraction, consolidation, and relocation of the region’s dominant aerospace industry. In its place, Los Angeles has emerged as the nation’s leading logistics and transportation center, largest manufacturing region, and it has capitalized on traditional strengths in media and creative fields, consumer goods, and tourism.

However, these sectors have not created regional champions of substantial scale. There are only 38 Fortune 1000 companies based in greater Los Angeles, compared to 62 for the Bay Area, 61 for greater Chicago, and 17 in just a single Houston zip code. Large firms may not be as innovative or exciting as startups, but they are important for attracting talent and capital, supporting local communities, and offering a comparatively stable wage base. The lack of major local banks is likely a contributing factor to the paucity of large firms. The most obvious reason is that there tend to be strong local biases to capital deployment in most asset classes. Despite the excitement of venture capital and its growing availability in Los Angeles, commercial lending is a more appropriate and important source of capital for most businesses. Today, the people who deploy that capital have a bias to deploy it elsewhere.

In addition to constraints on capital deployment, the lack of major banks has other less obvious effects as well. The Rise and Fall of Urban Economies is a must read for anyone interested in the Southern California economy and its development. It tracks the divergence in per capita incomes between the Bay Area and Los Angeles since the 1970s, and it attempts to offer insights into the underlying causes and offer potential solutions. It devotes a healthy chapter to studying relational infrastructure, or the linkages between firms. These linkages are important for reducing transaction costs, improving information and capital flows, and fostering innovation by facilitating the sharing of ideas. Compared to the Bay Area, an undeniable economic success story of the past few decades, Los Angeles does perform well in measures of interconnection:

“Strikingly, Greater Los Angeles’s business leadership has not just become less internally connected than the Bay Area’s leadership; its broad industrial divisions have also become much less linked than they once were.”

Los Angeles’ large industries tend to be relatively insular. The Hollywood, aerospace, apparel, and petrochemical industries, to name a few, live in their own fiefdoms, both figuratively and geographically, with relatively little overlap. This is a shame, as different industries explore technology and productivity-improving practices at different rates. They could all benefit from improving the overall level of human capital in the region and pushing governments to streamline the regions’ byzantine regulatory and tax regimes. We can’t even begin to imagine what innovations have been missed simply because the right actors haven’t engaged in sharing ideas. The broader tech and startup ecosystem can serve as a much-needed bridge, as it does in the Bay Area with substantial board overlap by venture capitalists, but LA’s venture community is still too small, and too few firms in the region have “grown up” with venture capital.

In many regional economies, traditional banks are the key facilitators of interconnection between firms in different industries, by virtue of their role in providing capital across industry lines. They also serve as important counsel either through participation on boards of directors, formal consulting, or informal advisory to their clients. They work alongside other organizations such as regional business forums, government economic development boards, and the non-profit/philanthropy circuit to link local actors. The extreme fragmentation of governments and non-profits across Southern California suggests that the region should be even more reliant than usual on banks to fill this role. Their absence means that Los Angeles’ broader business community has reduced political influence and missed cross-industry business opportunities. This isn’t the sole factor determining Los Angeles’s lagging wages and prestige compared to cities like New York and San Francisco, but it is an important contributor.

Los Angeles has a long history of reinvention and creativity in its economy, and it should be applauded for its current efforts to recast the city as a creative capital and technology hub. It certainly has many factors which set it apart from being yet another “me-too” attempt to clone Silicon Valley. However, as the city continues its efforts to foster innovation and high-wage industries, it should not forget the importance of seemingly staid and traditional actors like banks. The competitive advantages of incumbent banks and the incredibly low rate of new bank formation in the United States today mean that it will be harder than ever for an up-and-coming Los Angeles bank to achieve significant scale. When one does, the Los Angeles business community should rally to protect such an important asset from being swallowed by a distant giant.