Go ahead. Break up the big banks. Cut JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (NYSE:C) and Wells Fargo (WFC) down to a size where they're no longer too big to fail, jail, manage, regulate or challenge politically.
No question, it'd make a lot of big-bank bashers feel good. It'd probably eliminate some consumer abuses as well by getting rid of the "too big to behave" syndrome through which certain giants have come to regard the law as a pesky cost of doing business.
What breaking up the big banks will not do is make our financial system much safer.
The reason is simple. The real threat to the financial system is not a handful of banks so big that their failures would bring it down. The primary threat is that the system is so interconnected and complex that the failure of a bank big or small, or an institution that exists in the industry's shadow, can imperil everyone else with little or no warning.
History holds plenty of evidence. The Great Depression involved the demise of 7,000 mostly small banks. Many went under because they'd made loans to highly leveraged stock market investors and farmers who couldn't repay them. Big banks got into trouble lending to foreign governments that were supposed to be rock-solid but turned out to be more like quicksand. Sound familiar? Eventually, depositors lost confidence in banks of all sizes and withdrew savings precisely because they were not too big to fail. Goodbye banks. Goodbye functioning financial system.
Savings and loans stumbled into a crisis in the 1980s after lawmakers dramatically relaxed the regulations governing them. S&Ls jumped at the chance to compete for deposits by offering ever more competitive interest rates. Then they invested the proceeds in mortgages and other volatile assets whose risks they proved incapable of managing. When the boom turned into a bust, S&Ls began going belly up by the hundreds. Regulators proved clueless. Disgusted taxpayers got stuck with a massive tab. Change a few names and many of the headlines from that era would work well in this one.
Long-Term Capital Management got into another sort of mess in 1998.The relatively small, virtually unknown hedge fund run by a Nobel laureate had made complex and ultimately dead-wrong bets in esoteric derivatives. Federal Reserve officials and the people running giant investment banks soon concluded that they faced the prospect of either bailing out LTCM or watching the entire interconnected financial system get pulled under. This time it was Wall Street that footed the bill (except for Jimmy Cayne's Bear Stearns, which refused to pitch in).
Lastly, consider one of the biggest blowups of the most recent financial crisis. Until it struck, AIG was considered an ultra-safe insurer and not the sort of institution that threatened world finance. Eventually AIG, like LTCM before it, was recognized as having placed bets on derivatives that went against it on such a scale that it threatened to take down the insurer and an untold number of counterparties that were counting on it to hedge their own bets. Once again, the dominoes proved so close together that the downfall of one would topple them all.
When the housing boom went south, it didn't really matter whether the banks that had done the lending were Goliaths or peewees. What mattered is that they'd all made the same false assumptions and bad investments. It's what Ludwig Chincarini calls "crowded trades" in his book The Crisis of Crowding: Quant Copycats, Ugly Models and the New Crash Normal.
Regulators are relying too much on risk models and unproven stress-testing to ensure banks are not headed for trouble. Unfortunately these models being used have not been back-tested and provide a false sense of security. Reportedly, according to rumors floating about the FDIC, the former chief of the bank insurance pricing unit at the FDIC informed her managers that stress-testing had been performed by her unit when in fact, tests had not been done. Rather, the results were apparently discovered to have been fabricated. Not sure the outcome other than to note the former chief took her key employee and departed to the Federal Reserve to head up its stress-testing.
This shows the need for more oversight of actions by regulators and consultants. These entities are subject to much less internal governance standards than any regulatory official cares to let the public know. Internal watchdogs are ineffective for the most part as well as Inspector Generals with the agencies. The internal politics has captured these units long ago. I was most concerned that the FDIC went nearly five years including the period of the banking crisis without doing any internal audit or review of the large bank oversight & monitoring practices. My disclosures were muted. I was admonished in return for my efforts.
Models are not shared with the industry, or with other bank regulatory agencies. They remain a secret black box. Exam ratings and insurance assessment remain a secret as well to all but the subject bank. Basel capital standards are non-transparent and were entirely ineffective in protecting banks from serious hardship during the most recent financial crisis.
A number of studies show that leverage capital to assets is the best predictor to determine whether bank will hold up during a major crisis. Also, the larger the leverage capital, the better secured is the bank which should translate to better examination ratings, and lower FDIC deposit insurance assessments. Regulators are becoming less effective because they cannot keep pace with a rapidly changing industry. Large banks are able to acquire talent at any price which helps it out-manuever even the most informed bank examiner. A salary and bonus of a million plus can attract better talent than a $150,000 civil servant. Promontory Financial is reportedly paying some consultants (ex-regulators) a million dollars plus a year as well. One can see how this might put more urgency on it to sway former colleagues at the regulatory agencies.
Since regulators become less effective, the only way to prevent TBTF and bank failures is to increase the capital of all banks. Due to the heightened complexity of the large banks and the additional resources (regulatory examinations, monitoring and FDIC insurance protection) large banks should be required to have higher leverage capital ratios on a graduated scale based on asset size. The higher capital, if appropriately high enough, should exert pressure for the large banks to shrink to a more reasonable size.
None of this matters though if we continue to have a lack of corporate governance within regulator agencies and the big bank consultancies. We can do much better than the status quo. Investors, employees and the public deserve much better.
The only person in the country who would tell regulators "You don't need this information and I won't give it to you" is in a TBTF bank. Yes, maybe banning him from the industry for life would be almost as effective as breaking up Chase, but I wouldn't rely on that.