Radical fixes for 'too big to fail' gain support

By Alistair Barr, MarketWatch

Last Update: 9:01 PM ET Nov 6, 2009

SAN FRANCISCO (MarketWatch) -- If policymakers and regulators tackled the issue of too big to fail head on, the largest U.S. financial-services companies would be downsized dramatically, leaving the industry looking more like the utility sector: safe but slow-growing.

Bank of America (BAC), J.P. Morgan Chase (JPM), Wells Fargo (WFC), Goldman Sachs (GS) and Morgan Stanley (MS) are among the leading candidates to be broken up or shrunk significantly under such a drastic scenario, which has gained noted supporters in recent weeks.

"What you will have is another public utility sector, with banks growing roughly 4% a year, funded by deposits," Richard Bove, a financial-services analyst at Rochdale Securities, said in an interview.

For a vision of such a future investors need look no further than Citigroup Inc. (C), which is already being broken up under part-ownership by the government, Bove and other analysts say. American International Group (AIG), almost 80% owned by taxpayers, is also being slowly unraveled.

Since the financial crisis hit last year, the U.S. government has spent hundreds of billions of dollars investing in the nation's largest financial institutions, lending them cheap money and guaranteeing their debt.

While the effort probably averted another Great Depression, it's created a cadre of financial-services behemoths that are too big to fail.

Proposed reforms aim to prevent costly bailouts in future. But critics complain that these reforms could end up doing the opposite, by giving top institutions more-explicit government backing. That, in turn could lead to more risk-taking and even larger companies.

Radical solutions

As the reform proposals are chopped and changed in Congress, more radical solutions to the problem are gaining support.

Former Federal Reserve Chairman Alan Greenspan said on Oct. 15 that regulators should consider breaking up institutions considered too big to fail.

Such firms can borrow more cheaply than rivals because investors know the government will bail them out. That cuts competition and imperils the financial system, he explained during a speech to the Council on Foreign Relations in New York.

In the late 1990s, Greenspan supported rolling back the Glass-Steagall Act, a Depression-era law that prohibited commercial banks from owning or working with brokerage firms or participating in investment banking activities.

But last month, he said that, while arbitrarily breaking up institutions went against his philosophical bent, something must be done to tackle the too-big-to-fail issue.

Mervyn King, governor of the Bank of England, recently proposed separating traditional banks, which benefit from government-backed deposit insurance, from riskier market players. He also said it was hard to see why breaking up large financial institutions would be impractical.

"What does seem impractical, however, are the current arrangements," King said. "Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are."

'Absence of rules'

The current approach to financial reform is creating uncertainty among investors, because it's not clear what the government and regulators want to do with the industry, according to Nancy Bush, a bank analyst at NAB Research LLC.

Separating commercial banking and investment banking again would be "extreme," but it may be better than the confusion caused by recent regulatory efforts, she explained.

"Somebody should make a decision. We have no rules right now, and in the absence of rules, investors flee," Bush added. "We don't know capital requirements, or who will fail, or how many wounded players will be allowed to limp along, tainting the rest of the industry."

If Glass-Steagall is brought back in a new form, "at least we would know what to expect," she concluded.

Downsizing

Economist Henry Kaufman, a former Salomon Brothers executive who was on the board of Lehman Brothers (LEHMQ), favors downsizing institutions so that if they fail, they won't threaten the financial system.

In 1990, the ten largest U.S. financial institutions held about 10% of the country's financial assets. Last year, they held over 60% and the 20 largest probably held at least 80% of financial assets in the nation, Kaufman estimates.

This "financial concentration" gained momentum after Glass-Steagall was repealed and it accelerated again in the past year as the government bailed out the largest institutions, he explained.

"At a minimum, we should have financial public utilities," he said in an interview. "Preferably we should have institutions that are small enough so that when they fail, they just fail."