Breaking up the banks and restoring the Glass-Steagall Act to separate commercial banking from investment banking have mass appeal to populists, many in Congress, and to those seeking retribution for the global economic crisis and destruction of capital — and now, to even a handful of bankers, some of whom were original architects or beneficiaries of the financial supermarket model we have today, known as the universal bank.
The idea of breaking up the banks again gained recent attention with the surprising statement by Sandy Weill, former Chairman and CEO of Citigroup Inc., that universal banks should be broken up — to restructure institutions that have become too big to fail and that expose taxpayers. A few other former banking leaders have followed and expressed similar views, evidencing their personal journeys and metamorphoses, citing factors such as incentive structures and higher valuations.
Before hastening to enact new legislation, a phenomenon that often emerges after any crisis or disaster, it should be recognized that breaking up the banks would deny the need for scale and impair U.S. global banking competitiveness, not address so-called too big to fail, and it would not prevent another crisis brought about by unsound lending practices. Further, it does not address industry culture and accountability. While the diversification model of universal banks has been regarded as a benefit, some of the most diversified banking companies in the world suffered most during the crisis, which affected more than one line of business.
Banking is fundamentally a low margin, commodity business: deposits, loans, credit cards, information technology and numerous other banking products are mostly undifferentiated and generic. The obvious exceptions would be private equity, underwriting of debt and equity in inefficient markets, risk principal activity and other proprietary business such as complex derivatives. For most commodity products, banks must compete on the basis of superior relationship execution, an amorphous concept itself, and on reputation or brand.
For a commodity business, internally generated revenue growth may be limited to inflation plus a small premium at best. The ability to manage and reduce operating costs through workflow engineering or new processing technology to achieve economies of scale is critical to achieving target economic returns. In a commodity business, mergers allow fixed costs to be spread over a larger revenue base. To deny American banks global scale is to limit their effectiveness against institutions and countries that do not. Further, the basic industrial, commercial and agricultural businesses and the consumers of Main Street benefit from the strength and liquidity of the U.S. banking system.
Restoration of Glass-Steagall would not prevent the need for government intervention in another meltdown of Wall Street. Lehman Brothers was an investment bank whose demise sparked a global panic in credit and equity markets in September of 2008. Although it will never be known for certain, a rescue of Lehman might have averted that chain reaction. Too big to fail has never been adequately defined and would still prevail, with the need for government rescue of a failing commercial or investment bank. If a banking company with a balance sheet of $1 trillion or more is downsized to half that size, or even 25% of that size, its failure could still incite a domestic run on banks that extends beyond national borders. The key issue is whether a financial institution is deemed by the market and by regulators to be a system bank, a term for which there is no clear cut definition, yet generally refers to one that is so connected to trading counterparties, clearinghouses, corporations, and the general public that its insolvency would bring financial catastrophe to other parties and damage to the nation at large. Ironically, to some analysts, being deemed a system bank evokes confidence and facilitates interbank lending in many countries.
Breaking up the universal banks and returning to Glass-Steagall would have no bearing on the integrity of credit processes in the industry. The quality of mortgage loans — a basic product of commercial banks — was at the heart of the U.S. economic meltdown. Increasingly subprime in nature, those loans made on Main Street when aggregated into Mortgage Backed Securities and Collateralized Debt Obligations contaminated trading desks of the New York investment banks, and from Wall Street found their way into investment portfolios of pension funds and other investors all over the world. An integral part of Dodd-Frank, the Volcker Rule, which among other things prevents proprietary trading, does not affect the quality of asset creation.
Banking is about taking and managing risk: a bank commits capital, takes a risk that its client will not take, or provides financial advice, all for a return. To mitigate undue levels or concentrations of risk, even with oversight by boards of directors and executive management, more effective regulatory scrutiny is required. To achieve this, the regulatory framework comprising the Federal Reserve, Department of the Treasury, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, and other federal and state regulatory bodies needs to be vastly simplified.
There is no shortage of regulators. On a given day, there may be dozens of examiners from various agencies at a major financial institution, many of them with permanent offices there. Since regulators have been charged by Dodd-Frank with becoming more cognizant of system risk, it stands to reason that more compensation will be needed to attract the very best regulatory minds — individuals able to challenge the assumptions and trading algorithms of their counterparts, and examine corporate governance at the level of the board of directors.
Before rushing to reinstate a construct that was dismantled by market forces and technology over several decades, the culture and incentives of the industry must first be examined, along with the adequacy of penalties for financial excess and bad judgment. Further, the wisdom of publicly held investment banks needs assessment: when some investment banks were privately held, partners came to work each day putting at risk their personal capital — not the capital of the public.
The question is not how to make banking companies smaller and separate commercial and investment banking, but how to assure the safety and soundness of risk management practices in the financial services industry. If it were to happen, the case to break up the universal banks needs to be made by shareholders, not by Congress or regulators. Shareholders may determine if they are economically better off since the end of Glass-Steagall — as well as the end of laws that once precluded interstate branching and holding company acquisitions, such as the McFadden Act and Douglas Amendment.