Why the TBTF Debate is a Sideshow

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. 

The too big to fail debate is important. The risk in focusing too intently on it is that we'll once again end up fighting the last war while setting ourselves up to suffer big losses in the next one. For all we know, the real threat we now face is not another big-bank blowup but the unprecedented amounts of liquidity being pumped into the financial system by the very people who are supposed to keep it safe and sound.

Neil Weinberg is the editor in chief of American Banker. The views expressed are his own.