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.

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.