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Break Up the Banks

President Barack Obama delivered a stern and badly needed warning to General Motors (GM) and Chrysler about the need to come up with a credible turnaround plan, or prepare for a bankruptcy restructuring. But sadly, the President wasn't equally blunt when he summoned the nation's top bankers to the White House the other day for a kaffeeklatsch. Rather than simply urging the bankers to support his Administration's plan for reviving the financial system, Obama should have been far tougher with the chieftains of finance, telling them to break up their firms or stand aside and let the federal government do it.

If this seemingly endless financial crisis has taught us anything, it's that no financial institution can ever again become too big to fail. That means any mega-bank remaining standing at the end of this crisis will have to be split up either by voluntary divestitures or by old-fashioned trust-busting. (And yes, that means you Jamie Dimon and Lloyd Blankfein.)

JPMorgan Chase (JPM) and Goldman Sachs (GS), the respective firms that Dimon and Blankfein run, will probably emerge from the current crisis as two of the stronger U.S. banking players. But there's no guarantee that the next time a crisis hits, those firms won't be at the center of the problem, just the way Citigroup (C) and Bank of America (BAC) found themselves this time around.

Threats to Global Economic Stability

The only way then to prevent future trillion-dollar Wall Street bailouts is to carve the banks down to size. That way a failed financial institution can be wound down without threatening the stability of the global economy. Today's mega-banks are so interconnected that the collapse of any one of them threatens to bring down a dozen other major banks and financial firms.

Citi's role as a dealer and counterparty to $31 trillion worth of derivatives contracts—the third most for any U.S. bank—is reason enough that the regulators can't simply seize the company, as many have called for, and begin liquidating it ASAP. The immediate termination of all those derivatives contracts would cause immense pain to banks, hedge funds, nations, municipalities, and individual investors around the globe. And the fallout from a Citi liquidation would be far greater and longer-lasting than the tens of billions of dollars in damage caused by the unraveling of Lehman Brothers' far smaller derivatives book in September.

Make no mistake: There's a lot to like about the Obama Administration's new regulatory scheme for addressing some of the threats posed by mega-banks to the global banking system. We certainly need new rules for regulating out-of-control derivatives and the freewheeling trading strategies of hedge funds. But none of Treasury Secretary Tim Geithner's proposals get to the crux of the matter: We must keep banks from getting too big for regulators—and even their own senior executives—to tame.

An Updated Glass-Steagall Is Needed

One way to restore some sanity to the system would be for the Obama Administration to call for the passage of an updated version of Glass-Steagall, the Depression-era law that barred commercial banks from owning investment banks and other financial firms. The 1999 repeal of Glass-Steagall was a colossal mistake, permitting too much risk to be concentrated in a handful of mammoth banks. The law, which served the nation's banking system well for nearly 70 years, was a natural check and balance on the growth of financial firms.

Charles Geisst, a finance professor at Manhattan College and a noted Wall Street historian, says the repeal of Glass-Steagall was a green light to Wall Street to go hog wild. It opened the door to an explosion in risk-taking with derivatives and securitization. That model was emulated around the globe.

Geisst says it's too late to undo the globalization of the world financial system—the interconnectedness of derivatives makes that almost impossible. But it's not too late to revive an updated version of Glass-Steagall and break apart the giant banking behemoths that have emerged over the past decade since the law was obliterated. "The original Glass-Steagall wasn't just a banking law; it also was a very good form of antitrust law," says Geisst.

Prohibiting Outsize Market Dominance

A 21st century Glass-Steagall should bar certain banking combinations and impose caps on certain investment banking activities by commercial lenders. The goal should be to prevent a handful of banks from dominating the market for exotic investment products. It's plain crazy that 96% of the total notional value of all derivatives contracts is concentrated in the hands of five U.S. banks, which now includes Goldman following its conversion to a bank holding company. There probably also need to be some limits on the number of countries any single bank or financial firm can operate in.

"JPMorgan will need to get split up again," says Geisst. "You are going to separate commercial banking and investment banking again. And what we created with Citi was something that was too big to fail. We allowed an institution to be created that was too big for its own good and too big for its management."

The bankers will no doubt argue that all of this will stifle financial innovation and make it harder for companies to raise capital once the economy stabilizes. That may be so. But it's worth accepting a little less growth if it means avoiding more big bank bailouts down the road.

Business Exchange related topics:

U.S. Economic Stimulus

Global Economy

JPMorgan Chase

Goldman Sachs

Banking Industry

Goldstein is a senior writer at BusinessWeek.

Goldstein is a senior writer at BusinessWeek.

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