Editor At Large

Carving Up Big Banks Won't Work, Any Way You Slice It

Banks that are too big to fail are too big and should be broken up.

It's a simple, even comforting, solution to the risks posed by megabanks.

But it will never happen — and that's OK.

Barbara A. Rehm

Why? Because federal regulators have a workbench full of tools to tame the largest banks and the government wants to test them before it plows into the private sector with such an intrusive, irreversible step.

Critics claim the bailouts of 2008 undermined capitalism, and they are right. But arbitrarily breaking up the largest financial companies would strike a much bigger blow to our economic philosophy.

And it strikes me as strange that no one waving the "break 'em up" banner has answered fundamental questions like how big is too big or what's the best way to cut an institution down to size. Is it a strict asset cap, or some sort of concentration trigger? Should we carve banks up by business line, or perhaps by geography?

We've only had ultralarge financial companies for five years, and most of them bulked up by absorbing a weaker competitor during the crisis. Since passage of the Dodd-Frank Act in mid-2010, most of these banks have gotten smaller, bowing to both market forces and regulatory nudging.

Breaking up the big banks sounds a whole lot better in theory than in practice.

Imagine the circles policymakers would have to square.

Would you break up Bank of America but not Wells Fargo? Both are huge. Both provide valuable products and services to millions of customers. But Wells is more profitable and has a better management track record, so should the government let it stand while it carves up B of A? Or should they both be broken up? How would you feel about that if you were a Wells Fargo employee, shareholder or customer?

What about Goldman Sachs? It's the "great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money," right? So let's break it up and feel good about ourselves.

But where would that approach end? Who should decide which companies are worthy and which deserve death by government fiat? Do we really want the government making such calls? And if not, are you willing to see great companies dismantled because a similarly sized competitor isn't as strong or respected?

Wouldn't that take the politicization of financial services to new and scary heights? And don't forget we already have size limits on banks. Since 1994 federal law has prohibited any single bank from growing through acquisition once controls 10% of the nation's deposits. Dodd-Frank added a 10% asset cap.

But just months before the reform law was enacted, the Senate debated and rejected on a 61-to-33 vote a provision to crack down further on bank size. The Brown-Kaufman amendment would have restricted a banking company's nondeposit liabilities to 2% of the country's GDP (roughly $300 billion at that time) and prevented banks from leveraging their capital more than six times.

The Obama administration, led by Treasury Secretary Tim Geithner, has consistently rejected calls to break up the biggest banks, and the only sitting federal regulator who publicly supports the idea is Tom Hoenig, the former Kansas City Fed president who just joined the FDIC board.

Probably the most fervent advocates are former FDIC Chairman Sheila Bair, Independent Community Bankers of America President Cam Fine and Simon Johnson, the IMF official turned MIT professor who frequently writes and speaks on the topic.

Dallas Fed president Dick Fisher recently reignited the debate.

"I believe that too-big-to-fail banks are too-dangerous-to-permit," Fisher wrote in the Dallas Fed's annual report released last month. "I favor an international accord that would break up these institutions into more manageable size."

But beyond Fisher's vague "international accord," he has not explained how he would go about dismantling the largest banks.

His director of research, Harvey Rosenblum, penned a detailed piece for the annual report that has gotten a ton of attention.

In his essay, Rosenblum acknowledges that Dodd-Frank is likely to reduce risk in the financial system and lead some institutions to shrink. Market discipline is already eroding the big banks' cost-of-funds advantage, he notes, and credit rating agencies have lowered their scores for some large banks.

Still Rosenblum doesn't trust policymakers to pull the plug on a large financial institution. "Words on paper only go so far," he writes. "The pretense of toughness on TBTF sounds the right note," but it doesn't give policymakers "the foresight and the backbone to end TBTF by closing and liquidating a large financial institution."

Rosenblum can't know this — nor can anyone else. What we do know is that Dodd-Frank gave federal regulators numerous and wide-ranging powers to tame too big to fail institutions.

The reform law gave regulators the right to take over and liquidate any systemically important company, impose losses on shareholders and creditors and fire management.

All of these firms must submit and continually update living wills that lay out for regulators a resolution road map should they stumble. They are subject to harsh and repeated stress tests to gauge how well they would withstand economic shocks. They face higher and stricter capital and liquidity standards as well as limits on leverage and counterparty risk. In most cases, companies that choose to grow face even harsher constraints.

Other provisions crack down on risky trading, investment and derivatives activities.

Obviously, for any of this to work the regulators must translate these "words on paper" into tough, sensible rules, and then they must enforce them fairly and consistently.

Examiners have to be on top of what's happening inside these systemically important firms and pounce when something goes awry.

I realize that's a big unknown. Everyone — including the regulators — realizes the agencies missed the 2008 financial crisis. They overlooked gaping risk management holes because firms were booking massive profits.

And it's fair to question how well the agencies are implementing Dodd-Frank so far.

Personally I'm disappointed that no one in power — say, Geithner or Fed Chairman Ben Bernanke — has made it his mission to expand the corps of examiners dedicated to the largest banks. This people should be better trained and better paid.

But when push comes to shove, the regulators will act. Any giant bank that does not get its house in order, that cannot file a comprehensive living will, that does not impress during a stress test will be forced to reduce risk, raise capital and, yes, to shrink.

So while the "solution" sounds temptingly simple, Dodd-Frank should be given a chance to work before the government resorts to the drastic step of imposing arbitrary limits on bank size or scope.

Comments (10)
Having suffered through the worst economic disaster in the U.S. since the Great Depression, why is it so difficult for policy-makers to see that the first step in returning the nation's financial system to a sound footing is restoring the law enacted at the end the previous crisis? The law that successfully protected the country from a similar debacle for 66 years? The Banking Act of 1933 created the FDIC to restore faith in deposits at commercial banks AND Glass-Stegall which forced banks to stop acting like casinos. Hard to see how the country would not benefit from returning to a regulatory policy that proved itself over time.
Posted by jim_wells | Thursday, April 26 2012 at 9:35AM ET
Frankly, who cares if breaking up TBTF banks is a blow to our economic philosophy when letting them continue threatens a death blow to our economic survival? Frankly, there would be less of a problem with big banks if Glass-Stegall was fully restored, if effective controls were in place to curb modern abuses posed by casino banking, and if big banks had less political sway to capture the regulators. But Dodd-Frank provided little to none of this. So in its absence, break the big banks up. Then lets return those smaller and less politically powerful entitites back to the safe, sound and boring banking of yesteryear.
Posted by j.doe | Thursday, April 26 2012 at 10:03AM ET
Whether Dodd/Frank will fail or succeed or even remain is yet to be seen but will prove interesting at least.
What we really need to consider is , had or do regulatory agencies actually do their job, and what were they looking at over the past 9 years, and finally are all "pigs equal" or are some just more equal than others"???? In a pure capitalist system an institution as moronic and corrupt as some of those who were bailed out would be swiftly punished by the market.
It is not a matter of picking or chosing, but rather implementing policy specific to financial institutions, that would limit maximum size and giving a 5 year period for those already above same to spin off and restructure.
Posted by tfer | Thursday, April 26 2012 at 2:14PM ET
Barb, I compliment you on outlining some key issues. I want to point out to the commentators that the ending of Glass-Stegall allowed the banking system to survive. The integrated banks with one exception only needed liquidity when their was panic throughout the economy. The banks that created that panic were not banks that took advantage of Glass-Stegall. Countrywide, Washington Mutual were old fashioned mortgage banks. Bear Stearns, Lehman Brothers and Merrill Lynch were old fashioned investment banks. Citibank got into trouble the same way all the commercial banks got into trouble in the 1980's; holding too much correlated credit risk. AIG wasn't even a bank, and they got into trouble the exact same way. Reinstating Glass-Stegall is not going to prevent a similar crisis, it would only increase the probability the one might occur. More effective regulation is the only solution and yes, we are then relying on the regulators to do a good job and there is risk in that.
Posted by Tom White | Thursday, April 26 2012 at 3:19PM ET
I agree Tom. It's interesting how many people point to the repeal of Glass-Steagall as this big turning point. While I do think it helped to change the culture of commercial banking, loosening it up with more investment bankers, I don't think Gramm-Leach-Bliley is responsible for the financial crisis.
Barb Rehm, editor at large, American Banker
Posted by brehm | Thursday, April 26 2012 at 3:25PM ET
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