Big Bank Break-Ups Need to Wait: Dudley

NEW YORK ( TheStreet) - Breaking up big banks might not necessarily be the answer to ending "Too Big To Fail", New York Federal Reserve President William Dudley said in a speech Thursday.

In prepared remarks before the Clearing House's Second Annual Business Meeting and Conference, the Fed official said those calling for the break up of big banks were still short on ideas on how to do so.

"So far, advocacy for the break-up path has been strong, but without the detail to assess whether this is indeed superior to the course we are currently following," said Dudley in outlining the central bank's approach to tackling the issue of too-big-to-fail.

Too- Big- to- Fail (TBTF) is a moniker given to some of the largest firms whose size, complexity and global connections makes the entire financial system vulnerable to their failure. Bank of America ( BAC), JPMorgan Chase ( JPM), Citigroup ( C), Wells Fargo ( WFC), Goldman Sachs ( GS) and Morgan Stanley ( MS) fit the billing.

One of the biggest fallouts of the unprecedented bailout of Wall Street in 2008 is the perception that the government will not allow these firms to fail. That perception distorts market discipline because it allows big banks to get funding at lower rates than they would have if there was no prospect of a bailout. Critics say it also incentivizes these firms to take more risks without the fear of consequences.

In the aftermath of the crisis, regulators have taken steps to reduce the likelihood of failure. Raising capital and liquidity requirements has been an important step in this direction. The Volcker rule's attempt to rein in risk-taking is another.

Dodd Frank also aims to reduce the cost of such failures by asking banks to outline how they will be wound down in the event of distress through "living wills."

"We have made some progress on the TBTF problem, particularly in reducing the likelihood that a large complex firm will reach the point of distress at which society faces serious costs. But we have a considerable ways to go to finish the job and reduce to tolerable levels the social costs associated with such failures," Dudley said.

Critics of Dodd Frank argue that designating some banks as systemically important and requiring them to carry higher capital ends up creating a false perception of safety. They also believe that there is no fool-proof way to prevent failure.

In the wake of the JPMorgan multi-billon dollar trading loss earlier this year, the call to break-up big banks has grown louder, with everyone from former FDIC Chair Sheila Bair to former Citi Chair Sandy Weill weighing in.

Others have called for the reinstatement of Glass- Steagall which separated investment banking and commercial lending activity. Many believe the repeal of Glass Steagall created the banking behemoths we have today.

Dudley isn't convinced that this is the answer. "With respect to Glass-Steagall, it is not obvious to me that the pairing of securities and banking businesses was an important causal element behind the crisis. In fact, independent investment banks were much more vulnerable during 2008 than the universal banking firms which conducted both banking and securities activities," he said. "More important is to address the well-known sources of instability in wholesale funding markets and give careful consideration to whether there should be a more robust lender of last resort regime for securities activities."

An analysis of breaking up big banks should answer several questions, according to Dudley, including how to force divestiture, whether to split firms by activity or reduce it by size, what is the appropriate size, the cost to replicating support services and so on.

He however did not rule out big bank break-ups completely. "A blunter approach may yet prove necessary," if the current steps to address TBTF fail, he said.

-- Written by Shanthi Bharatwaj in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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