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.

Both deals worked out beautifully for the U.S. government. The FDIC's insurance fund didn't lose a dime when selling Washington Mutual to JPMorgan Chase, which is most unusual in the aftermath of any bank failure. Former FDIC Chairman Sheila Bair helped negotiate the sale of Wachovia to Wells Fargo, possibly avoiding another bank failure that would have been 2.5 times as large as Washington Mutual, measured by total assets. Washington Mutual wound up being the nation's largest bank ever to fail, with total assets of roughly $307 billion.

JPMorgan had already grown through its acquisition of the nearly bankrupt Bear Stearns in June 2008. And Bank of America ( BAC - Get Report) added purchased Countrywide Financial during 2008, increasing its mortgage business and, in hindsight, its liability, before greatly expanding its brokerage and wealth management businesses, not to mention its balance sheet, through its purchase of the floundering Merrill Lynch on Jan. 1, 2009.

So yes, the "big four" retail U.S. banks as a group have expanded their deposit market share in the wake of the crisis, although Citigroup ( C - Get Report) didn't go on a buying binge.

Looking again at the big six, including Goldman Sachs ( GS - Get Report) and Morgan Stanley ( MS - Get Report), three grew their balance sheets over five years through the end of 2012, while three shrank. JPMorgan's total assets increased 51% over the five-year period, while Wells Fargo, grew its total assets by 147%, mainly from the Wachovia purchase. Bank of America saw its balance sheet expand by 29%. Meanwhile, Citigroup, Goldman and Morgan Stanley saw their balance sheets shrink by 16%, 15% and 25%, respectively, as part of their plans to trim underperforming business units and lower risk-weighted assets.

According to data provided by Guggenheim Securities, the big six aren't quite so big when taking into account the size of the U.S. economy. "While the median Large Cap Bank represents about 50% of their respective economies, the U.S. Large Cap Banks only represent about 15%," Mosby wrote in a report on May 13. Looking deeper, JPMorgan's assets are equal to roughly 16% of U.S. GDP, while Bank of America is at 15%, Citigroup is at 12%, Wells Fargo 9%, Goldman Sachs 5%, and Morgan Stanley's assets are equal to about 5% of U.S. GDP.

The median for large-cap banks worldwide is for total assets to equal about 47% GDP, according to Mosby.

Naysayers will rightly point out that U.S. banks' total assets don't include the net fair value of derivatives. If the U.S. large-cap banks' assets were inflated to include the net derivatives, "the top 3 U.S. Banks become the largest in the world," according to Mosby, but would "still represent meaningfully less than the median 47% of their respective annual GDP."

Breaking Them Up Through Brown-Vitter.

That brings us back to "too big to fail" and the question of whether or not to break up the big banks. "The Large Cap Banks have increased their Tier 1 common equity levels from just under $400 billion in 2009 to over $800 billion currently," according to Mosby. Putting it another way, the group has more than doubled its Tier 1 common equity since before the credit crisis.

The Terminating Bailouts for Taxpayer Fairness Act -- with the cute TBTF acronym -- was introduced by Senators Brown and Vitter last month, and the senators minced no words, by saying their proposed capital rules would ensure "that megabanks gamble with their own funds -- not taxpayer dollars."

Considering how important the availability of credit is to U.S. businesses and consumers, that is a rather chilling statement, implying that the banks don't do any of us any good.

Moving beyond the populist rhetoric and the excellent television sound bites, the senators proposed that U.S. regulators "walk away" from the Basel III agreement, which has been signed by the U.S. and 26 other countries representing all major world economies. Rather than following Basel III's risk-based approach to capital requirements, Brown-Vitter would require banks with total assets of more than $500 million would be required to have common equity of at least 15% of total assets.

If Brown-Vitter passes, the big banks, in the words of the senators, "will be faced with a clear choice: either become smaller or raise enough equity to ensure they can weather the next crisis without a bailout."

That last statement is contradicted by recent history: The failures of Bear Stearns, Lehman Brothers and even Washington Mutual were caused by liquidity shortages and not a lack of capital. For Bear Stearns and Lehman, reliance on overnight funding was an immediate problem, causing near instantaneous runs on those companies. This problem, and ways to prevent it, are discussed in part two.

Brown-Vitter emphases a preference for common equity rather than preferred or trust preferred equity, most of which has already been excluded from regulatory capital under Dodd-Frank. More importantly, the simplified approach under Brown-Vitter means the denominator of the capital ratio will no longer be risk-weighted.

Under Basel III, cash has a zero risk-weighting, so it is not added to risk-weighted assets and it doesn't increase a bank's capital requirement. Direct obligations of the U.S. government have a 20% risk-weighting. Mortgage-backed securities with AAA or AA ratings have a 20% rating. A-rated MBS have a 50% risk-weighting, while BBB paper has a 100% risk-weighting, and BB paper has a 200% risk-weighting under Basel III, because of the higher likelihood of default.

Brown-Vitter would treat cash and the lowest quality junk bonds, or even nonperforming loans, as having the same amount of risk. This is counterintuitive, since it could only lead to banks taking more risk, since there would be no capital penalty for doing so.

So rather than taking a direct approach to breaking up the largest U.S. banks, Brown-Vitter seeks an indirect approach of raising the capital requirement so high that the banks and their investors would eventually throw in the towel, after realizing their returns on equity would be too small to justify their size. If only those simplified capital requirements weren't so dangerous.

Arguments Against Breaking Them Up

"We have had a system that has tried to keep banks small since Andrew Jackson," Mosby says, adding that the restrictions against preferred and trust preferred equity under Dodd-Frank, and proposed under Brown-Vitter, are counterproductive. "The capital protecting depositors is all value and the productive part of other sources of capital is that they are much lower in cost. It would be better to allow banks like other corporations to use preferred stocks and to enhance their profitability, because that is your first line of defense."

"Quality is what matters, not just how big you are," he says.

Mosby in his May 13 report listed seven "alternative proposals" to breaking up the big banks. These include allowing banks to "utilize the full array of capital sources," as described above. The analyst's proposals also include a risk-based approach to capital requirements and two other elements of Dodd-Frank: Limiting "broker/dealer activities to just market making," and finalizing "an orderly liquidation process" for failing institutions.

Mosby also recommends that there be retention of risk for lenders in all securitization processes, to avoid the sort of mortgage repurchase mess Bank of America is working through.

Mosby has directly addressed what he sees as the core of the systemic "too big to fail" problem: "We believe forced collateralization and limitations on concentrations can help to minimize this risk, which is the primary reason any Large Cap Bank failure has been deemed too risky in the past," he wrote. He added that the finalization of orderly liquidation processes by the large banks, known as "living wills," along with agreement on the processes by regulators, could be "the final gesture that removes the too-big-to-fail implied guarantee."

The large banks can, and hopefully will, present clear and logical alternatives to end the perception of implied guarantees of government bailouts, once and for all.

The politicians need to think twice before breaking up our largest banks. Out of the 52 largest banks worldwide, ranked by total assets, only six are U.S. banks. That is a rather small number, considering that the U.S. is still the world's largest economy. Only two U.S. banks are included among the top 10. JPMorgan Chase is the world's eighth largest bank, and Bank of America ranks ninth.

If Brown-Vitter were to pass, it would possibly succeed eventually in its goal of forcing the largest U.S. banks to break up, but in the meantime, the banks would be struggling to push loan rates high enough to turn a decent profit on their higher capital levels, which might lead to at least a temporarily stifling of credit availability. That could be quite a brutal shock to the economy.

Rafferty Capital Markets analyst Richard Bove took a much tougher tone last month, after a draft version of the Brown-Vitter bill was leaked, calling the bill "anti-American legislation." In a note to clients, Bove wrote on April 8 that passing Brown-Vitter would "defeat the Federal Reserve's current monetary policies and create a recession of unlimited duration."

"What is almost laughable about this legislation, if it was not so critical, it is using a faulty view of American history as justification for its passage," Bove wrote. "It harks back to a time when this country's financial system was replete with Depression and bank failures as the example of what the country should return to."

According to Bove, forcing the big U.S. banks to shrink creates a vacuum that "allows the Chinese banks to grow at a faster rate into areas of global finance previously dominated by Americans," which can hasten an eventual switch to the yuan as the world's reserve currency, instead of the U.S. dollar.

When analyzing the requirements and effects of Brown-Vitter, Bove wrote that the big six banks would need to raise $500 billion in common equity, while the "the rest of the selected parts of the industry would have excess equity."

The problem with this scenario, according to Bove, is that "the big companies will not be able to raise this equity . . . and the small companies will not be able to absorb the excess loans that would have to be divested by the big banks."

That's a disruptive recipe for a terrible recession or depression as credit dries up, and possibly an even bigger government bailout in order to shore up the economy.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.