Big Banks, Deleverage or Perish

Banks today resemble an obese person who must get healthy quickly or die. If we can't break up the banks by decree, they will crumble under their own weight.

Financial reform is an interest of mine and I recently encouraged Jamie Dimon, the CEO of JPMorgan Chase, to embrace the breakup of "too big to fail" financial institutions. TBTF is not an isolated issue, however. It is a symptom of a much bigger problem, that can't be resolved by willful and well-meaning actions of standalone actors – whether persons, institutions or governments. A concerted and coordinated effort of all the parties involved would be necessary for, but still won't guarantee success.

True, there's political will and public demand for reform here in the U.S. Dimon himself supports reform on some level, as he pointed out to me in an email. But if financial reform is to have any real effect then it would have to be done in sync with reforming the European banks.

I admit ending "too big to fail" is easier said than done. Let's look at the playing field. Every government or private player in the financial markets is highly specialized in its own niche; they all follow a certain playbook. The Federal Reserve can only cut or raise rates and buy or sell assets. European leaders are too busy bringing Germany and Greece to a common denominator while experimenting with austerity. Our own Congress is obsessed with tax cuts and spending cuts. But the Fed's cash is not making its way to the consumers' pockets; European austerity creates more problems than it solves; U.S. Congress is mired in gridlock.

And yet, if the efforts to mitigate a future crisis are to succeed, all of these entities would have to come together and synchronize their actions. Ben Bernanke (or his successor) would have to exercise a flawless (not too fast, not too slow) exit from the Fed's ongoing quantitative easing program. Congress would have to pass a bill that deals with real problems and not ideology. Even if we miraculously find ourselves watching President Barack Obama sign a TBTF Breakup bill, we would still have to get European regulators and legislators to implement a similar initiative.

Each one of these events is necessary, but insufficient on their own for financial reform to proceed. All of the above would have to be executed impeccably and preferably in a close and coordinated sequence. And say we do all of that. What is the probability of all of that happening in the right manner at the right time and without a glitch?

But there's a bright side, albeit with a cruel irony, to such institutional failure.  If we're powerless to break up the banks, then we're also powerless to bail them out should they fail. There will be no more bailouts, because we've simply run out of options. What can we do differently from what we're already doing now? Infuse banks with cash? Lend to them at zero rates? It's all being done now, on a massive scale.

As such, being too big itself resolves the TBTF problem in a most Darwinian manner. This is the kind of concept that Nassim Taleb describes at length in his book, "Antifragile: Things That Gain from Disorder." Like a morbidly obese person, banks have to get healthy or die. Bloated size, leverage and managerial dysfunction will do the work the public can't. If we, with all our playbooks and rules and protocols, can't take care of the system's dislocations, the system's dislocations will take care of themselves – a laissez-faire dream! In some bizarre twist of fate, Bernanke's actions that inadvertently increased banks' size can seal their fate and prove to be the ultimate break-up mechanism.

In theory, there is one available cure of size that does not require an act of Congress or a consensus among the U.S. and the Europeans: voluntary deleveraging. Sure, it's boring. It would have to be done gradually and it would have an adverse effect on stock valuations (lower leverage translates into lower return on equity). But taking this bitter medicine now will prove invaluable when the utility of being big shifts from beneficial to detrimental. (As a side note, considering that European banks are more leveraged than U.S. banks, could it be possible that U.S. banks are already aware of this dynamic and are doing something about it? If so, then I sense some great preemptive play going on here!).

If our current or future Fed Chairman is clumsy in ending the QE and fails to rein in inflation quickly enough, then being leveraged 20 or 30 times is going to be like being a turkey close to Thanksgiving. And besides the QE exit – which everyone is currently obsessed with – there can be other adverse events (terrorist or cyberattack, natural disaster, some other "fat tails") that are just as damaging to being big, dysfunctional and in debt. When one is leveraged 20 times, a 5% drop in the value of assets will wipe out the equity; at 30 times the equity cushion is even thinner (Lehman was leveraged around 30 times when it failed).

But there's someone who will be immune to the repeat of 2008. During the last five years, the Average Joe has defaulted on his mortgage, paid off his debts, saved and has learned to live within his means simply because no one came to his rescue. Back in 2008, the Fed intended for the average consumer to have cash in his pocket so spending could jumpstart the economy, but that cash got stuck on banks' balance sheets. Because the Fed's cash never made it to average consumers' pockets, they inadvertently learned to be frugal. Lack of a monetary crutch has left these people in much better financial shape than the banks and thus better prepared for whatever comes next. It's been a tough few years for the Average Joe, but, in the process, he became antifragile.

If I were a highly leveraged financial institution, I would quietly preempt the Fed by slowly deleveraging and pray to monetary gods that the QE exit is as flawless and orderly as possible. Average Joes, on the other hand, should stock up on popcorn.

Katya Grishakova left the financial industry after spending more than a decade at various Wall Street firms. She is now a board member of ACT NOW, a New York progressive organization.