End 'Too Big to Fail' Without Breaking Up Banks — Here's How

It seems nearly every politician is jumping on the band wagon to end too big to fail banks, but almost no one is suggesting a realistic way to bring it about without inflicting serious damage on the economy. We suggest a plan that will get the job done.

Banks are essential to economic growth. People enjoy cursing banks from time to time, but in truth society cannot prosper without the loans and access to the capital markets they provide to businesses and individuals.

There have always been bank failures and always will be. The trick is to allow sufficient risk taking to promote economic growth but not so much that it leads to widespread bank failures and panic.

Given the long history of financial crises, we should acknowledge that regulators are not capable of preventing them without turning banks into government-controlled public utilities that are inhibited from taking sufficient risks to support economic growth.

We need a system that assumes failures will occur but are handled in a way that does not devastate the economy or result in taxpayer bailouts. We must make clear that in all bank failures all creditors, other than insured depositors, will face risk of loss so that neither the FDIC nor taxpayers will lose money.

Requiring large firms to increase their common equity capital to breathtaking levels — say above 9% of assets — is not the answer. That lowers return on equity to the point that banks will be unable to raise sufficient capital and will shrink their balance sheets, impeding economic growth. The very companies and individuals who most need bank loans will be denied access. This is happening in Europe and the U.S. today. Because equity capital is permanent and cannot declare an "event of default" when it perceives the risks to be excessive, it's only marginally effective in imposing discipline on management. Moreover, equity holders have upside potential and are therefore more tolerant of risk than creditors.

If total equity and long-term debt were set at a minimum of 20% of assets and all creditors other than insured depositors are at risk, it's difficult to imagine that the FDIC, much less taxpayers, would ever incur losses on a failure. This plan would not only protect the FDIC and taxpayers, it would impose market discipline to make failures much less likely. A risky bank would have to pay higher interest — sending a clear negative signal to management, the board, investors and regulators — and ultimately might not be able to issue long-term debt, forcing it to curtail growth.

When a large bank failed, the FDIC would put it into a bridge bank that would operate under FDIC control with new management and directors. The bridge bank would continue to serve depositors and borrowers, while leaving the equity, long-term debt and perhaps a portion of the uninsured deposits behind in a receivership with no guarantee of recovery. The bridge bank would be reprivatized as soon as possible.

We also must focus on improving regulatory performance by getting back to the fundamentals. There are three warning signs when a financial institution is approaching the danger zone. We need regulators who have the political will and independence and the financial skill to take swift, strong actions when these signs develop.

The most important warning sign is concentration of risk. Most financial institutions fail because their asset and liability risks are too concentrated by geography, industry or product line.

Large banks should be able to diversify their risks more broadly than small banks. All other things being equal, a well-diversified trillion-dollar bank operating its business in a similar fashion across numerous states is at less risk of failing than a billion-dollar bank operating in only one or two states or communities with limited products.

Texas banks during the 1980s were small by today's standards and were among the most profitable and highly capitalized in the country … just before nearly all of them collapsed. They failed because they were concentrated in Texas commercial real estate and energy loans.

Admittedly, if a large bank does not diversify its risks, it can cause considerably more damage than a small bank, which is why it is so important to have strong and effective market and regulatory discipline the larger a bank becomes. But size per se is not a bad thing.

The second warning sign is inadequate liquidity. Bear Stearns and Lehman Brothers reported relatively high levels of capital, but they failed because of insufficient liquidity — the proverbial run on the bank.

It's stunning that those institutions were allowed to operate with balance sheets approaching a trillion dollars funded primarily by short-term wholesale liabilities. Inadequate liquidity has been a primary cause of failures forever. Why can't management and regulators get this right?

The third warning signal is significant exposure to capital markets on either the asset or funding side, or worse yet on both sides. Capital markets have seized up in the past and will in the future.

Russia made up less than 1% of the world's economy, yet the Russian debt crisis of the 1990s resulted in a worldwide financial crisis and meltdown and brought down Long-Term Capital Management. Cyprus, with a population of just 800,000, recently rattled worldwide capital markets.

A company that syndicates and sells a large percentage of its loans and other assets is far more at risk of failure than a company that originates and holds assets. The former has little or no "skin in the game" as it sells the loans it originates and pays less attention to prudent underwriting standards.

Capital markets turmoil can severely disrupt the business of a company that relies on an originate-and-sell business model. With little or no recurring income because originated assets are sold not held, such an operation must keep "feeding the beast" — originating and selling more and more regardless of the risk and markets. When this model also relies primarily on short-term wholesale funding sources, it's especially toxic.

It's naïve and contrary to all historical experience to believe that Dodd-Frank and incredibly complex, backward-looking capital and risk models will end too big to fail. Smarter and more independent and effective regulation, coupled with greater market discipline by placing uninsured bank creditors at risk, will significantly reduce moral hazard and end taxpayer bailouts.

Richard M. Kovacevich is the retired chairman and CEO of Wells Fargo. William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is a senior managing director and global head of financial institutions at FTI Consulting, the chairman of Fifth Third Bancorp and author of Senseless Panic: How Washington Failed America.