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Breaking Up is Hard to Do

Posted by: Matthew Goldstein on March 31

President Obama delivered a stern and badly needed warning to the nation’s automakers about the need to come up with a credible turnaround plan, or prepare for a bankruptcy restructuring. But sadly, the president wasn’t equally as blunt when he summoned the nation’s top bankers to the White House the other day for a coffee klatsch. Rather than simply cajoling the bankers into supporting 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.)

JPMorganChase (JPM) and Goldman Sachs (GS), the respective firms that Dimon and Blankfein run, will likely emerge from the current crisis as two of the stronger US 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 like Citigroup (C) and Bank of America (BAC)found themselves this time around.

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 inter-connected 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 US 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 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 free-wheeling 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.

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, served as a natural check and balance on the growth of financial firms.

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 US 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.

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.

Reader Comments

Hugo van Randwyck

March 31, 2009 01:55 PM

Finally BW has an article that says what the public has been saying, with no ifs or buts! Good article. Maybe the writer could also do a sales forecast of lending and see the over-capacity in the banking sector. The mortgage bankers association show a more than 30% drop in mortgaging, so why do we need all these banks? A simple demerger into 100 to 150 separate banks for each bank, would do it. Also ban overseas banks from investing in residential real estate. Yes, split the functions into separate banking businesses, similar to as before. Maybe the writer could do some scenarios, showing options, with examples from others, showing the parts are worth more than the whole.

Jim Bullard

March 31, 2009 03:03 PM

I know for my future banking needs I am more comfortable working with my local bank. I would rather see my money support a locally owned bank than one of these mega-bank (greedy risk takers).


March 31, 2009 03:34 PM

Finally, someone agrees with me -- reinstate Glass-Seagall. But why stop there; go a step further...reinstate the ban on inter-state banking, and limit the functions of bank holding companies -- hence if Bank Holding Company A holds banks in States A,B,C,D -- these banks in said states serve as individual entities -- sort of like subsidiaries to Bank Holding Company A.
Mutual Funds can not short sell stock nor buy the same way, seperate the creators of derivative products from the buyers/ sellers of such products...If I create a CDO, SWap or CMO..I should not be allowed to hold it on my books; If I sell it, I should not be allowed to buy it back -- essentially, create an auction (as opposed to OTC) market for these entities -- this increases transparency and makes the market much more liquid (as there will always be a ready and able counter-party).
Get banks back into the business they have been in for centuries -- lending and depositing.
LASTLY -- create more transparency from the FED.


March 31, 2009 03:54 PM

It's painfully obvious that limiting institutional size and reach could have prevented what's happened, but the question is, what could dismantling them just now expose -- mere hollow shells? There is something very suspicious in the way that they seem to be holding the nation hostage. An interview with Hank Paulson on the subject might be very interesting.


March 31, 2009 04:15 PM

Banning overseas banks from investing in real estate only serves to protect the banks from themselves. What regulators worldwide need to do is limit the size of banks to institutions small enough to be insurable against failure. The FDIC also needs more money. Leave deriviative and hedge activities to billionaires. Make it known that derivative and hedge activity will not be insured at any price.


April 9, 2009 07:15 PM

The current banking system has more problems than we can count.

The first step is to nationalize the banks. The second step is to systematically remove those individuals responsible for this financial crisis. The third step is twofold:

- investigate and prosecute those responsible.
- enact legislation that will prevent this from ever happening again.

Step 4 - create a constitutional amendment that will prevent this legislation from being repealed.

step 5 - When the banking system is stabilized and the checks and balances are in place privatize the banks.

Thank you for your interest. This blog is no longer active.



BusinessWeek's Adrienne Carter, Jessica Silver-Greenberg, and David Henry deconstruct the mysteries of high finance, Wall Street, and hedge funds for pros and ordinary investors. E-mail them directly if you've got tips about big deals, a hedge fund, or even securities industry gossip.

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