To Solve TBTF Problem, Nudge Shareholders

The supersized bank problem is still alive. The top ten domestic banks control more than 75% of all banking assets. The largest six are now twice as big as the rest of the top 50 banks combined. Furthermore, these venti-financials continue to grow despite efforts like the Dodd Frank Act.  

Threatened government breakups of or caps on supersized banks are easier to do in theory than in practice. A scalpel, not an axe is needed. Consequently, the best hope for reform is from within the banks, not imposed by government. Shareholder impatience over lagging economic performance is likely to be the catalyst triggering a supersized bank breakup.

These institutions are difficult to justify on economic grounds. They trade at significant discounts to book and breakup values. For example, Citi trades at 60% of its book value. Additionally, it lost almost 90% of its value since the crisis. Furthermore, these giants trade at a 40% discount to their smaller and more focused large regional bank counterparts. Performance issues with their high cost and capital intensive universal banking business model underlie these discounts.

The size and complexity of the supersized banks makes them inefficient, hard to manage, difficult to control and rife with conflicts. This is especially true concerning capital allocation, incentive plans and the ability to monitor and control multiple layers of risk. Next, many of the disparate business units are worth more to a different, more focused owner utilizing a higher value added strategy. These factors more than offset the alleged diversification and cross-selling benefits of universal banking. Investors can achieve diversification more efficiently on their own. Cross-selling benefits are as illusory as merger-related synergies. The banking supermarket is an elegant theory unsupported by results.  

There is no valid economic reason for these entities to exist – yet they do exist. They exist based upon governmental policies. The unspoken Too Big to Fail policy provides an implicit subsidy to these banks by guaranteeing their senior debt. This is in addition to the limited deposit guaranty which all banks enjoy. Thus, they can raise debt, which represents a substantial portion of their funding, at artificially low rates. Experts believe the subsidy is worth an estimated $4 to $5 billion per year for each of these trillion dollar plus banks. Thus, banks are incentivized to grow to achieve this status. Supersized institutions are, in effect, the new government-sponsored entities joining Fannie Mae and Freddie Mac. Consequently, they enjoy an advantage over regional and community banks.

Regulators can solve the supersized bank problem by removing barriers to market forces. The most important step is to offset the implicit senior debt funding subsidy. Regulators could simply state that senior creditors would no longer be made whole in a bank failure. The credibility of this statement in a crisis is questionable.

An alternative is to offset the funding subsidy by imposing higher capital requirements as suggested by the Federal Reserve Board Governor Daniel Tarullo. The requirement should be high enough to encourage the banks to become more focused. The level of common equity to assets should be well above the Basel III requirement, and probably closer to 13% to 15%. As raised by Federal Deposit Insurance Corp. Director Thomas Hoenig, this would ensure these banks are too safe to fail without government subsidies. The decline in returns would create a value gap too large to ignore for the supersized banks. Reluctant managers and boards would be forced by their shareholders to break up their financial conglomerates similar to the dismantling of the industrial conglomerates during the 1980s. This pressure may be one of the factors behind Vikram Pandit's recent resignation as CEO at Citi as the bank's performance was poor even with the subsidy.