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I was recently inspired by the editorial Shelia Bair wrote advocating breaking up the mega banks in the interest of the banks' shareholders as well as taxpayers. I think she is spot on, but I thought I would put forward a slightly different idea. My view is that instead of breaking up the banks, mega banks should shrink their balance sheets and right-size their businesses. This is in the best interest of the nation, and shareholders will also benefit when the shares trade above tangible book value.

Too Big to Fail

Shelia Bair in a television interview said that there is a procedure to wind down the big banks, and that they would not be bailed out by the government in the event of crisis. I think this is just plain inaccurate. If a big bank like JPMorgan (NYSE:JPM) or Citigroup (NYSE:C) failed, the risks to the financial system would necessitate another bailout. Unfortunately, this is the key lesson we learned from the collapse of Lehman Brothers. The only way we can really overcome (or at least improve on) too big to fail, is to the make the mega banks smaller. The irony of it is, shrinking the banks is also in the best interests of the banks' shareholders. If a plan is in the best interest of the nation, and also shareholders of the companies involved, there is little excuse for the plan not to be enacted.

Bank Stocks - Shareholders have Already Voted with their Feet

Mega banks, the ones that are supposed to have the greatest talent and infrastructure in the nation, are trading at sharp discounts to tangible book value. I highlighted this for the top six banks in one of my previous articles. These discounts imply that shareholders are not giving any value to the banks' businesses. Whether it is their huge deposit bases, branch networks, or white shoe investment banks, shareholders are saying none of it has any value. The combination of all these great business is trading below the capital of the firm. In a utopia, the banks would just close up shop and return all assets to customers and capital to shareholders. One of key reasons for the sharp discounts to tangible book exhibited in bank stocks is that investors have no faith in the banks' balance sheets. Investors don't understand them (there is not nearly enough information on the quality of the banks assets), so there is no way they can really evaluate risk and value.

Management's focus should be on Shareholder Value, not Marketshare

Management of these big banks seems to have forgotten that their top objective should be to increase shareholder value. As a shareholder of Citigroup, I would much rather the company be half its size, and $60 dollars a share, than the behemoth it is it today with its stock price languishing below $30. Many of the smaller regional banks trade above book value, why shouldn't Citigroup? Since the difference in valuations is so stark, management should really be thinking of drastic measures.

Shuttering Investment Banking Divisions/Trading Operations

Management of banks like Citigroup should take a good hard look at themselves and ask if they are really doing a proper job. They need to face the fact that the investment bank divisions they are running are actually being valued at below $0 on their balance sheet. If Citi just shuttered the investment bank, and used the capital for stock buybacks, a significantly higher IRR could be generated. In addition, closing down the investment bank would go a long way towards reducing systemic risk by shrinking the asset size of the institution (and thus making it less big to fail). Of course, by shuttering the investment bank, many would argue that we would be putting a lot of people out of work. My retort would be that this is capitalism working at its best. Investment bank employees are the best and the brightest. They will find other jobs and need not be protected by anyone. If management is so concerned, they can be offered jobs in other divisions (although I doubt many of them would accept).

Big bank CEOs need to see the writing on the wall. If they fail to take actions that are in the best interests of shareholders, they will eventually lose their jobs in favor of someone who will.

Disclosure: I am long C, MS, BAC.

Source: Mega Banks Must Shrink: Great For The Country, Better For Shareholders