Calls to break up the big banks have surfaced again. This is understandable as the Big Four – JPMorgan Chase, Bank of America, Wells Fargo and Citigroup – accounted for almost half of total 2015 domestic banking assets. Predictably, the large banks argue that their size yields benefits outweighing their systemic risks to the economy. Public-policy-based breakup efforts quickly degenerate into an endless political debate unlikely to be resolved before the next financial crisis. Furthermore, an industrial policy requiring bank breakups would be overreach by the government. An alternative, market-based, bottom-up approach letting shareholders, not government, determine the "right" size based on economic performance should be considered.
If size truly justified the heft of the Big Four, then they should have superior operating and share price performance. Yet only Wells has generated a return on equity consistently above its cost of equity since the financial crisis. The bank's stock price trades above book value, albeit below its pre-crisis level. JPMorgan's recent results show ROE equal to its cost of equity. Its stock price trades around book value. Citi and Bank of America have failed to cover their cost of equity since the crisis. Their stock prices trade at less than 70% of book. Thus, except for Wells, the alleged benefits of size and global scope have failed to translate into superior performance at the Big Four. The real issue is why these banks and their boards continue to cling to underperforming legacy assets and business models, which depress returns and value. Perhaps it reflects the absence of market challenges to weak internal governance.
Ordinarily, capital market discipline represented by activist investors would surface to question underperformance at public firms. Activists would confront management and their boards with strategic changes to improve results and share prices. Examples include Carl Icahn's efforts at AIG. Activism, while increasing at some smaller institutions, faces significant regulatory barriers.
The primary source of the barriers is the Bank Holding Company Act. Under the act, investors deemed in control of a regulated bank holding company become subject to banking regulations. They would then face continued banking supervision, capital requirements, source-of-strength obligations and possibly the need to discontinue certain activities.
These restrictions act as a de facto poison pill discouraging potential activists from accumulating, either alone or acting in concert with other investors, a large enough ownership position, usually 1% to 5%, to challenge bank managers. Avoiding being deemed in control frequently requires signing passivity agreements. This effectively negates the role of an activist investor and any hope for capital market discipline. The law enshrines poorly managed and governed institutions by maintaining the status quo precisely when change is needed.
This is why recent breakup proposals by Public Citizen regarding JPMorgan and Citi and KBW concerning Citi are likely to fail. Such proposals cannot obtain the significant shareholder support needed given passivity requirements which prevent the formation of shareholder coalitions.
Active, not passive, shareholders are needed to drive the required changes in strategic direction. This requires reducing the regulatory barriers to shareholder activists. An important first step would be a less restrictive interpretation of control requiring passivity under the law. For example, regulators could grant activists interim exemptions from the Bank Holding Company Act while their challenge is unfolding. Regulators would still retain approval rights concerning any proposed changes including capital plans and other fundamental changes. The increased risk of activism itself would introduce capital market discipline, letting market forces take effect without the need for difficult-to-pass new laws.
Failure to reduce regulatory barriers to activism simply prolongs the "too big to fail" problem for taxpayers and shareholders.
J.V. Rizzi is a banking industry consultant and investor.
Corrected March 29, 2016 at 10:10AM: An earlier version of this article wrongly suggested that Carl Icahn had agitated for change at MetLife. He has, however, cited MetLife's plan to break itself up in his efforts to get AIG to do the same.