Breaking Up (a Big Bank) is Hard to Do

NEW YORK ( TheStreet) -- Kudos to former Citigroup ( C) head Sanford 'Sandy" Weill for reinvigorating the debate on how to resolve hard-to-manage, poor returning and 'too big to fail' universal banks.

Weill -- who is largely credited with creating our present-day 'too big to fail' banking system after successfully advocating for the dismantling of the Glass Steagall Act -- won't likely be a key part of breaking up universal banks overnight, even if his Wednesday morning CNBC interview is a compelling case.

But breaking up universal banks starts with change in surprising places and entails a difficult, multi-year effort.

For instance, analysts and industry professionals note that even if broken up, many of the independent units of dismantled mega-banks could yet pose the risks that spurred Weill's change of heart.

Independent investment banks may remain the threat to investors, taxpayers and the economy that they were during the financial crisis. Meanwhile, the creation of 'too big to fail' bank balance sheets - primarily JPMorgan, Bank of America and Citigroup -- may have engendered lingering structural problems within traditional deposit taking and lending banking businesses.

"In order to solve the issue of too big to fail, you've got to fix the problem of too small to succeed," says Nancy Bush, a banking sector analyst and head of consultancy NAB Research.

After Weill convinced regulators on the merits of universal banks in Citicorp's 1998 merger with Travelers and had the Glass Steagall Act 'shattered', Bush notes that an era of industry consolidation and balance sheet growth, followed by the financial crisis and hundreds of billions in bailouts has wildly distorted the overall U.S. banking system.

That's because the creation of 'too big to fail' banks like Citigroup, which took $45 billion in taxpayer funds to survive the 2008 financial crisis, have an implicit government and taxpayer subsidy which make them more compelling as depositories. Ratings agencies generally agree, with many like Moody's calculating the size of a government backstop as key in their analysis of a bank's riskiness.

In contrast, greater perceived ratings or depositor risk means that the cost of funding for smaller community or regional banks may be higher than those that are deemed too large to fail, giving depositors a false sense of comfort. "We need to create the perception and reality that the community banking system is strong enough to not be failing in another period of volatility," says Bush.

In the Federal Reserve Bank of New York's July economic policy review, the regulator provided a striking illustration on the growth of assets at the nation's largest banks - called bank holding companies - and that fall under its jurisdiction. "U.S. BHCs as a group control well over $15 trillion in total assets, representing a fivefold increase since 1991," noted the New York Fed.

"Today, the four most complex firms," measured by the number of separate legal entities included within the holding company structure, "each have more than 2,000 subsidiaries, and two have more than 3,000 subsidiaries," while "in contrast, only one firm exceeded 500 subsidiaries in 1991," added the NY Fed, in its review, highlighting the increasing complexity of universal banks.

Look no further than TARP, or the Troubled Asset Relief Program, which injected emergency capital into banks during the crisis as a gauge on the health of America's banks. While most bailout funds have been repaid as the nation's largest banks returned bailout money, the majority of recipients - hundreds of small lenders - still cling to government money.

The ability for community banks and small regional players to consolidate or even eat up divested pieces of unwieldy universal banks may also be key to finding a replacement for 'too big to fail' banks.

For instance, FBR Capital Markets analyst Paul Miller says that not only should Bank of America ( BAC) split or spin off its Merrill Lynch investment banking unit - bought under former CEO Ken Lewis for nearly $50 billion the day Lehman Brothers collapsed - it should also split its commercial banking operations regionally, undoing other mergers.

Such an advised breakup would undo a generation of consolidation for Bank of America, which expanded it into a national commercial bank. Meanwhile, after merging with investment banks, brokerages and insurance conglomerates like Travelers, Citigroup is already well on the way of breaking up what was Weill's 'financial supermarket.' In fact, the bank is currently running off an $850 billion portfolio of unwanted assets called CitiHoldings, as it tries to shrink a balance sheet that swelled to nearly $2 trillion prior to the crisis.

Even if current regulations and those soon to be implemented through the 2010 Dodd Frank Act help to restore a more sound and competitive commercial banking industry in the U.S., all is still not well for independent investment banks, which disappeared during the financial crisis, and continue to be characterized as 'systemically important financial institutions,' a regulatory moniker for 'too big to fail.'

Were JPMorgan or Bank of America to separate their investment banks from their retail operations, would they operate as true standalone units or just become bank holding companies like their parent?

The answer is not so clear.

After the crisis, the notion of a true standalone investment bank has all but disappeared after Goldman Sachs ( GS) and Morgan Stanley ( MS) converted to BHC's in the fall of 2008 to gain access to the Federal Reserve's discount window and survive the crisis. "It is a major, major mistake for Goldman Sachs and Morgan Stanley to have bank holding company status," says Bush of NAB Research.

In fact, even if Weill's comments sparked a revival of the debate on 'too big to fail,' with Congressional figures already debating his Wednesday morning comments, change may first come from abroad.

UBS ( UBS), Credit Suisse ( CS) and Barclays ( BCS) may be first-movers in shuttering, divesting or spinning off their investment banking units, notes Roy Smith, a professor of management at New York University's Leonard N. Stern School of Business. Swiss regulators are already asking that UBS and Credit Suisse cut their risk assets - mostly held in investment banking units - by over half, as a means to protect their vaunted asset management businesses and the Swiss economy.

Smith - a former general partner at Goldman Sachs ( GS) -- notes that British regulatory efforts like the Vickers Commission to 'ringfence' traditional bank deposits are also most to lead to a spinoff of Barclays' investment banking unit.

In the prospective breakups of UBS, Credit Suisse, Barclays - or even Citigroup or Bank of America -- Smith notes that investment banks would likely transfer significant assets to the balance sheets of their deposit-taking parents and look for independent investors to fund a spinoff. "This has been done in the past when American Express broke off Lehman Brothers," says Smith.

Operational change would also likely engender structural change, notes Smith who points to the change in investment banking business models from intermediating and advising risk -- to taking and storing it, by way of asset securitizations and writing derivative products. Since roughly the same time as the breakup of Glass-Steagall, Goldman Sachs, for instance, has roughly quadrupled its assets. Interestingly, since the firm's 1999 initial public offering, revenue has only roughly doubled and profits have grown by an even smaller measure.

Meanwhile, a hindrance to such breakup efforts, ironically, may be new regulations that seek to solve 'too big to fail' banks. Many bank chief executives, highlighted by Jamie Dimon of JPMorgan, argue to shareholders that once regulations are completed and executed upon, financial sector investors will be more supportive of the universal bank model -- eventually benefitting from diversification.

Recently, the nation's largest banks have submitted, and with the exception of Citigroup, passed Federal Reserve stress tests to their capital and assets, in a check up on their soundness that's seen as a way to prevent future crisis and bailouts. Universal banks - deemed by the Fed to be 'systemically important financial institutions' - also recently sent regulators living wills that outline their plans to sell assets and weather a financial crisis. New Dodd Frank Act regulations of derivative trading and prohibitions on proprietary investments also take effect, in coming quarters.

Still, in spite of these new post-crisis rules, the likes of Dimon argue that global businesses and customers require global investment and commercial banks.

Amid a financial sector rethink that may actually metastasize quicker in Europe, those hoping to see an end to 'too big to fail' may be smart to pin their hopes on common shareholders, over regulators, politicians or ex-CEO's like Weill, who may have a change of heart.

" The forces of economic gravity are just so overwhelming," notes NYU's Smith of an end to 'too big to fail' and bank earnings that struggle to eclipse the capital costs.

"It won't happen next month or next year. Five years from now it will happen," says FBR Capital Markets' Miller of bank breakups. In a world of broken up banks, it is the deposit-taking lenders that Miller says will likely appeal to investors. "Just look at where Wells Fargo is trading relative to the broker dealers," he adds.

For more on the contrasts between U.S. bank earnings and business models, see why Warren Buffet shuns investment banks. See why Barclays' scandal was born out of a derivatives bet for more on Libor litigation.

-- Written by Antoine Gara in New York

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