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Big Bank Phobia: Not Too Big to Fail

This is the first of a three-part series rebutting the three most popular approaches toward lowering the systemic risk of large U.S. banks. Make sure to read Part 2, on liquidity vs. capital reserves and Part 3, on the folly of bringing back Glass-Steagall.

NEW YORK ( TheStreet) -- There are three main approaches being taken by the enemies of large U.S. banks, and all of them are bad ideas.

Five years after the peak of the credit crisis, nearly three years after the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed, and more than two years since the last "final disposition" of government bailouts for the "big six" U.S. banks, it remains quite stylish for members of both political parties to continually bash the large banks, saying they represent a continued threat to the U.S. taxpayer.

Plenty of political concern is justified when considering just how out of control mortgage lending and securitization practices had become before the real estate bubble burst during 2007, and how the big banks have increased their U.S. deposit market share in the wake of the crisis.

While most banks big and small have repaid bailout funds received through the Troubled Assets Relief Program, or TARP, and the bailout has turned a tidy profit for the federal government, it would be best to avoid another bailout. Dodd-Frank is nowhere near being fully implemented, but there's no question that the banks are much stronger, with much higher capital levels and better liquidity, not to mention better loan underwriting practices, than they had before the crisis.

Meanwhile, the Federal Reserve has greatly expanded its role as regulator of the nation's largest holding companies, and has been running annual stress tests to make sure the banks could weather a "severely adverse scenario" of a swift and unprecedented recession, while remaining well capitalized and continuing to make loans.

So what is the best way forward? According to Guggenheim analyst Marty Mosby and research analysts at his firm, proposals for bank reform in Washington are focused on three ideas:
  • Break up the big banks. The is the aim of the recent proposal by Senators Sherrod Brown (D., Ohio) and David Vitter (R., La.), which would have U.S. bank regulators "walk away" from Basel III and significant portions of Dodd-Frank. Under Brown-Vitter, the largest U.S. banks would simply be required to maintain common equity levels of at least 15% of total assets. With no risk-weighting for assets, these would be very high ratios indeed, which the senators have said would likely lead to the "megabanks" breaking themselves up.
  • Raise banks' capital requirements high enough to make failures very unlikely. This is different from the Brown-Vitter proposal since it incorporates a risk-based approach. Indeed, this is what we are seeing with the Federal Reserve's stress-test focus on capital strength through periods of economic adversity.
  • Bring back Glass-Steagall. There are plenty of voices clamoring for investment banks to be separated from commercial banks, as they were under the Banking Act of 1933. The Federal Reserve was already taking a rather liberal approach to Glass-Steagall even before the Graham-Leach-Bliley Act of 1999 formally ended restrictions against investment banks affiliating with commercial banks.

Below we discuss why breaking up the big banks is a bad idea. In part two, we discuss why a regulatory focus on capital strength is not enough to ensure banks' abilities to withstand severe economic stress. In part three, we discuss why bringing back Glass-Steagall would actually make the investment banks much more likely to fail.

The 'Too Big to Fail' Banks Ain't So Big

You've no doubt heard time and time again how terrible it is that the "big four" retail U.S. banks actually increased their deposit market share over the past five years, despite the bailouts. The big factors in this phenomenon were JPMorgan Chase's (JPM - Get Report) purchase of the failed Washington Mutual from the Federal Deposit Insurance Corp. in September 2008, and the purchase of the troubled Wachovia by Wells Fargo (WFC - Get Report) on Dec. 31, 2008.
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