By becoming smaller, banks may no longer be considered a threat to the entire economy. Banks are shackled but stronger

In this evolving era of financial reform, the nation’s too-big-to-fail banks are either at death’s door or destined to become bigger and badder than ever.

Either way, Washington is the epicenter of a chain reaction that could revamp the country’s financial institutions. Banks could merge to survive the heightened scrutiny caused by the enforcement of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection law, or they could break themselves up so they no longer appear on the radar screen of some newly empowered regulators — Treasury, the Federal Reserve, the Federal Deposit Insurance Corp. and others.


“For those banks not already too big to fail, Dodd-Frank contains powerful incentives to bulk up,” warned John Dearie, executive vice president for policy at the Financial Services Forum, which represents many of the nation’s largest banks.

But the exact opposite could also happen if those institutions try to escape tighter oversight by shedding the divisions they picked up during the 2008 meltdown. By becoming smaller, the banks may no longer be considered a potential threat to the entire economy by federal officials.

“We could see a lot of bigger banks break up into smaller institutions because of these issues,” said Fred Cannon, director of research as the brokerage house Keefe, Bruyette & Woods. “We consolidated in the United States a huge amount during the crisis. Bank of America combined with Countrywide, combined with Merrill Lynch. Wells Fargo consolidated with Wachovia.”

At this crossroads — more than three years since the devastating collapse on Wall Street — perhaps the most apt description of the country’s largest banks is shackled but stronger.

Wall Street no longer appears as mighty as it once was, even after government initiatives like the $700 billion Troubled Asset Relief Program helped it weather a catastrophic recession that cost several million Americans their jobs and homes.

Citigroup plans to lay off 4,500 employees, and Bank of America announced it will let go of 30,000 workers. Even huge bonuses — once fiercely defended by CEOs of big banks — are shriveling, with Morgan Stanley reportedly trimming compensation by 20 percent and Goldman Sachs by more than 26 percent.

Cash bonuses across Wall Street were off their 2006 peak by $13.5 billion in 2010 and are expected to fall further, according to the office of the New York state comptroller. Still, that doesn’t mean the financial sector’s flush past is history.

“The regulations are still in flux,” said an analyst in the comptroller’s office. “You need the economic conditions to stabilize. They’re still sorting through the mess. It’ll take a little while.”

One reason banks currently are less profitable is because they are setting aside cash ahead of new federal standards requiring them to increase their capital reserves. That gives them less money to loan and invest at a profit but establishes a stronger buffer in case another financial scourge strikes.

“Right now in the banking industry, you have the survivors,” noted Wayne Abernathy, executive vice president for policy and regulatory affairs at the American Bankers Association. “It’s a stronger banking industry from the point of its balance sheets.”

In a newly issued report, the Financial Services Roundtable claims the industry is healthier because the largest banks have increased the amount of core capital on hand 50 percent over the past four years.

“It’s always tempting to look for [a] dark cloud behind [the] silver lining, but in this case, the silver lining is paramount,” said Steve Bartlett, president and CEO of the association. “The large banks and insurance companies have to be well capitalized for the economy to recover.”

Bartlett described the increased requirements as a positive for the moment but ones that might change if regulations continue to pile on.

“A rib-eye steak is a good thing, but if you eat them three times a day, it’s a bad thing.”

Many industry executives said the new rules will deprive them of potential earnings. Banks are facing new restrictions on trading for themselves, encountering far more rigorous examinations and are not able to launch financial products as they once did, they claim. As a result, regional banks might have to go on an acquisition binge to improve their economies of scale.

“Sadly, this will be one of the many unintended consequences of regulation,” Deutsche Bank co-CEO Anshu Jain told Bloomberg TV in late January. “It is hard to see what the spate of regulations that we’ve seen unfold over the last 18 months would do other than consolidate our industry any further.”

An increase in mergers could be stopped by a group of proposed federal regulators awaiting Senate confirmation.

The two nominees to lead the five-person FDIC board — Martin Gruenberg as chairman, Tom Hoenig as vice chairman — both are sympathetic to ending “too big to fail,” according to Senate staffers.

Neither nominee has come against fierce partisan opposition in the Senate, unlike other regulators put forward by President Barack Obama. Democrats and Republicans alike have praised Hoenig, the former chief executive of the Kansas City Federal Reserve.

Should he be confirmed, Hoenig has been upfront about what his mission would be: whittling down banks whose breakdown could cripple the country.

“The existence of too-big-to-fail financial institutions poses the greatest risk to the U.S. economy,” Hoenig warned last year in a heavily publicized speech. “We must make the largest institutions more manageable, more competitive and more accountable. We must break up the largest banks.”

The FDIC and regulators might find ways to encourage banks to reduce their size through capital requirements and other levers, one financial industry lawyer told POLITICO.

Regulators could take pre-emptive actions, the lawyer explained, since the government is not necessarily equipped to dissolve a bank as large as a Citigroup, which has reported almost $2 trillion in assets and $1.75 trillion in liabilities.

The issue is essentially over whether it’s healthy for 10 banks to hold 90 percent of the assets, explained Joe Lynyak, a lawyer specializing in financial regulation at the Pillsbury Winthrop Shaw Pittman law firm.

“There is a policy debate that is still going on right now as to whether we really want to have 10 really large banks or several dozen smaller banks,” Lynyak said. “The jury [is] still out on what is likely to occur.”