Hey, lets break up the big banks. Yeah! That would show those Wall Street fat cats and solve a lot of problems to boot especially the risk that taxpayers could be tapped again in a panic under the too big to fail doctrine. The banks wouldnt be too big, right? One reason we had the last crisis was deregulation, namely repeal of the Glass-Steagall law separating commercial and investment banking.
Well, thats the argument anyway, boiled way, way down. Even Sandy Weill, who built Citigroup into the behemoth it is today, recently jumped on this bandwagon.
I admit the break-up-the-banks idea is attractive on the surface. Years ago, economists Milton Friedman, John Tobin and others pushed a notion called narrow banking. Banks that held government-insured deposits would be restricted. Theyd operate almost like public utilities. They could make traditional loans, but none of that masters-of-the-universe stuff. No collateralized debt obligations, no credit default swaps, etc.
The rest of the financial world would be largely free to whoop it up, with funding sources limited to high-wealth investors who would penalize reckless brokerages by quickly yanking their money. Everyone would know that no government guys or gals would ride to the rescue.
Former Kansas City Fed President Tom Hoenig, now a director a the Federal Deposit Insurance Corp., has a proposal generally along these lines. But its not clear this idea would eliminate bailout risk, and breaking up the banks may not be possible, at least in the way advocates seem to envision it. Even if Congress was willing to plunge into this issue again highly unlikely anything it coughs up would be full of loopholes.
Technology has melded stuff together so much that the line between commercial and investment banking is not easy to draw, said Bert Ely, a Alexandria Va.-based banking consultant.
Even if we went to some version of narrow banking, how could we know the lightly regulated part of the financial universe wont still pose a threat? After all, the entities that set off the panic, Bear Stearns and Lehman Brothers, had no commercial deposits. The repeal of Glass-Steagall, Ely observed, was totally irrelevant to the too-big-to-fail issue.
Which takes us to the real question: whether a collapsing brokerages counterparties would be forced to eat losses, and whether that prospect would trigger the kind of freeze-up we saw in 2008, when banks ceased doing business with each other, paychecks were on the verge of bouncing and suppliers couldnt be paid. We were truly on the edge of a precipice.
As former Fed chairman Paul Volcker has said, nobody wants to be the one who triggers a financial collapse. In the face of a potential catastrophe, Treasury and the Fed would probably start bailing.
Maybe one solution is simpler than the debate over bank breakups suggests. The financial author William Cohan argues that to change bankers behavior, change how theyre rewarded.
Under his plan a banks top people wouldnt be paid unless the entire firm has pre-tax profits; no more skimming compensation from the revenue an individual banker generates. More: The top 400 people in each bank would have their personal net worth on the line every day, as in the days when Wall Street was run by private partnerships. The firm loses, they lose.
Cohans idea would dramatically change how Wall Street views risk.
In any case, the market itself may break up the big banks. Theyve become ungainly blobs with chronically low shareholder returns. Expect hedge funds and vulture capitalists to move in, buy up blocks of shares and start pushing for breakups.