Big Bank Break-Up Is Already Under Way

NEW YORK ( TheStreet) -- Don't expect regulators to break up big banks anytime soon. They are hoping that the market will do it for them.

"Through regulation, stress tests and Basel Capital standards, they are going to make life uncomfortable for big banks," according to KBW political analyst Brian Gardner. "The multiples of large banks already lag that of regionals. What regulators would like to see is shareholders step in and force bank managements to break up their banks," he says.

The call to break up big banks has strengthened after Federal Reserve Chairman Ben Bernanke admitted for the first time at a recent conference that "Too Big to Fail is not solved and gone. It is still here."

"'Too Big To Fail' was a major source of the crisis and we will not have successfully responded to the crisis if we do not address that successfully," Bernanke told reporters.

Bernanke was acknowledging what many big bank critics including Massachusetts Senator Elizabeth Warren have been arguing -- that the market still expects big banks to be rescued in a crisis, even though new rules under the Dodd Frank Act are designed to prevent future bailouts.

The market's perception, however misplaced, gives big banks a funding advantage over smaller banks in the market. A Bloomberg study estimated this implicit market subsidy to be over $80 billion, though some in the financial industry have disputed that number.

The perception that banks are too big to fail also may provide banks with an incentive to take on more risk.

Stirring up even more controversy, Attorney General Eric Holder recently said that the size of some financial institutions and their impact on the economy weighed on the Department of Justice's ability to successfully prosecute them. In effect big banks were now "Too Big to Jail."

That has led to more calls to break up the big banks from both sides of the political aisle. Ohio Democrat Senator Sherrod Brown and Louisiana Republican Senator David Vitter are crafting legislation that would cap the size of big banks.

Still, while the political rhetoric against big banks is on the rise, regulators might not be in favor of mandating bank break-ups, according to KBW's Gardner.

"Regulators are wary of mandating a break up especially after banks have raised so much capital and the economy is growing modestly," says Gardner. "For all the talk that regulation should be countercyclical, regulators are human and tend to be pro-cyclical. They are going to be wary of direct intervention."

Instead, Gardner expects that regulators will simply make business unprofitable for big banks.

Indeed, in Congressional testimony last year, Bernanke said that post-crisis regulations requiring large banks to hold higher capital and subject them to a greater supervision would "take away the advantage of size."

"Market forces themselves will make it attractive to downsize, rationalize and so on," said Bernanke.

Bank stock performance has improved over the past year on the back of the housing recovery, but big banks are no longer able to deliver the returns on equity they once did.

Regulators have raised capital standards and dictate what they can or cannot do with their capital. Big banks have been effectively banned from considering further acquisitions. They also need the Fed's approval to raise dividends and buy back shares, and the regulator has been tightfisted in handing out approvals for big capital deployment plans.

Late last year, a group of shareholders called for the breakup of Citigroup ( C), as its stock constantly traded below book value. The SEC has allowed Citigroup to block the shareholder vote on the potential breakup.

But shareholders' demand for better returns have forced Citigroup to shrink. The bank has in the last few months embarked on a massive restructuring operation to boost returns to shareholders. Citi is in the midst of slashing 11,000 jobs, closing branches and plans to exit several unprofitable markets that fail to deliver on targets..

Other banks are also set to get smaller. Bank of America ( BAC) has been selling off non-core assets for the last few years and continues to reduce its balance sheet.

CLSA analyst Mike Mayo has frequently argued that big banks should break up and has even pushed JPMorgan Chase ( JPM) to do so. CEO Jamie Dimon has resisted such calls, arguing that a diversified business model offers more value than monoline businesses. The bank has grown bigger since the crisis, even as its competitors have shed assets.

Still, JPMorgan's multi-billion dollar trading loss last year has given further fodder for critics and the bank is facing tougher regulatory scrutiny.

At the conclusion of the Federal Reserve's recent stress tests, JPMorgan and Goldman Sachs ( GS) were given only a conditional approval for their deployment plans, with the regulator citing weaknesses in their capital planning.

The Fed is also using the stress tests to nudge banks into less risky businesses.

"JPMorgan Chase, Morgan Stanley and Goldman Sachs, three of the larger capital markets-intensive banks were all dinged in the stress tests," notes Gardner. "Regulators have given a clear guide of what they want to see going forward."

Banks have been reconfiguring their trading and capital markets businesses in anticipation of the Volcker rule, which prohibits proprietary trading and reins in risk-taking activities.

They are far from through with their restructuring efforts. "In the next 12-18 months there is going to be a lot of internal pressure at banks. Management is going to have to evaluate what are core parts and what is really superfluous," says Gardner. "It is already happening. It is just happening slowly so you can't see it."

-- 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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