Breaking Up the Banks: How Likely Is Legislation?

In a note to clients yesterday, Paul Miller of FBR Capital Markets wrote:

We are hearing that discussion of breaking up large financial institutions that pose systemic risk to the market is gaining traction on the Hill. At this point, discussions are in the early stages, but we understand that an amendment addressing breaking up institutions deemed “too big to fail” could be introduced in the House over the next few days. How does one define “too big to fail” and how would the divestiture process work - these are good questions that Congress will have to address as the discussion moves forward. To our understanding, any amendment that could be introduced in the coming week would likely be vague and would give the regulators discretion to determine which institutions qualify as “too big” and how to address the risk they pose to the system.

Doesn’t sound like it would amount to much. A “vague” amendment directing regulators to look into breaking up TBTF banks won’t lead to much, not when regulators have made clear they have no interest in breaking up big banks.

Just a reminder for readers, after she gave a speech complaining about TBTF at the Economist’s Buttonwood Conference, I asked Sheila Bair if she would favor policies to proactively shrink/break up big banks. She said “no, I don’t know how we would do that.”

And breaking up banks is only half the battle. While it’s very important to get commercial banks out of the trading business, if derivative books don’t shrink dramatically systemic risk won’t have gone away.

Neither Bear nor Lehman had a commercial bank. But the size, opacity and interconnectedness of their trading books posed huge risks for the system.

Speaking of the systemic risk posed by derivative books, there’s a very interesting and relevant tidbit in Andrew Ross Sorkin’s new book titled “Too Big to Fail.”

Not long before AIG (AIG) collapsed, CEO Bob Willumstad went to Tim Geithner — then head of the NY Fed — and asked that AIG be made a “primary dealer,” giving it access to the Fed as its lender of last resort….

He left Geithner with two documents. One was a fact sheet that listed all the attributes of AIG FP [the division run by Joe Cassano that blew the company up] and argued why it should be given status as a primary dealer. The other–a bombshell that Willumstad was confident would draw Geithner’s attention–was a report on AIG’s counterparty exposure around the world, which included “2.7 trillion of notional derivative exposures, with 12,000 individual contracts.” About halfway down the page, in bold, was the deatil that Willumstad hoped would strike Geithner as startling: “$1 trillion of exposures concentrated with 12 major financial institutions.”

You will bail me out or I’ll bring the whole system down with me.

Until they neuter the derivatives business by putting all contracts on exchanges, enhanced “resolution authority” will probably be meaningless. Regulators still won’t be able to shutter the largest financials because doing so would cause the systemic event they’re trying to avoid in the first place.

Comments

[doubleguns:]

Expect lots of noise from Washington but no action. Washington still needs to collect bribes for reelection.

Smaller banks means smaller bribes.

Nov 05 10:32 AM

[Ferdinand E...:]

Breaking up banks is part of some crank conversation in a London wine bar. What gives it so much importance in this forum.

Nov 05 10:45 AM

[logicalthought:]

doubleguns,

While I laughed at (in a good way) and recommended your comment, keep in mind that if the public's outrage at the big banks is large enough, calculating politicians may figure they can get more votes by NOT taking money from the big banks, and instead railing against them on the nightly news.

Nov 05 11:52 AM

[candooman:]

Breaking up the banks is easily and effectively done in two steps:

1) reinstate Glass-Steagall Act (cancel the 1998 act by Gramm - the name of which escapes me - that essentially repealed GS).
2) regulate all derivatives, CDS, etc. as espoused by Blesley Born when she headed the OTC before being pushed out by Rubin, Greenspan and Summers.

Ask Volker and Born to spearhead the effort, with Born back in the OTC to get it going. These two civil servants will be more than happy to serve again if Obama asks then too. They both love their country very much.

For more than 60 years, until repealed, GS served our nation very well. History has shown that what Born wanted to do at OTC was the right thing to do and the crash of 2008 showed her prediction was, unfortunately for us, very accurate.

Nov 05 05:34 PM

[swaps:]

Sheila Blair should be terminated. Ask a couple of MBA classes how to best break up the banking system - and reward the winning group with million dollars jobs as czars of the financial restructuring.

To say the banks can't be broken down into smaller parts doesn't consider how the Soviet Union broke down into smaller components and emerged as a stronger Russia.

Dumb people in charge in the U. S.

Nov 06 08:26 AM

[TinyTim:]

"Sheila Bair “no, I don’t know how we would do that.”

Hell, just ask the Europeans.
This is all about regulatory capture.

Nov 06 12:54 PM