“It’s time to break up the largest financial institutions in the country!” Bernie Sanders declared during his fiery presidential campaign kickoff on Tuesday. “If a bank is too big to fail, it is too big to exist!”

These days it’s not just socialists like Sanders who want to break up the big banks. So do liberals like Elizabeth Warren of Massachusetts and Sherrod Brown of Ohio, and even conservatives like David Vitter of Louisiana and John McCain of Arizona. Sure, the megabanks say that would be un-American, but who cares what they say? The Wall Street bailouts of 2008 proved they really were too big to fail, and their ungrateful reactions to the government’s largesse were almost too arrogant to believe. It would be fun to take a hammer to those bloated money machines, if only to watch their overpaid CEOs squeal.

That doesn’t mean it would be smart.

Breaking up the banks is one of those ideas that sound great in theory but less so in reality, a no-brainer until you run it through your brain. It’s not that size doesn’t matter at all, but the debate over size has been absurdly one-sided, ignoring the benefits of bigness, the potential costs of breakups, and what’s already been done to address the too-big-to-fail problem. With Wall Street salaries and bonuses once again as exorbitant as they were before the recent financial crisis, there will be huge pressure on 2016 candidates to prove their hostility to financial elites; on the Democratic side, Sanders and Martin O’Malley are already calling for bank breakups, so Hillary Clinton will surely be tempted to join them. But before financial disintegration becomes a populist litmus test, people ought to understand what it would mean.

For example: Did you know that the financial institutions at the heart of the 2008 crisis were not the very biggest banks? That the very biggest banks were actually indispensable to defusing the crisis? That the U.S. banking system is far less top-heavy than its foreign counterparts? It’s possible to know those facts and still support the Too Big to Fail, Too Big to Exist Act, the chainsaw of a bill that Senator Sanders and Congressman Brad Sherman filed in early May. But they’re important facts.

Before I explain, I should disclose that I helped former Treasury Secretary Timothy Geithner with his memoir about the recent crisis. But you can’t blame Secretary Geithner for my views; I was writing favorably about the financial bailouts (which, by the way, ended up turning a profit for taxpayers) even before I met him. In any case, nobody wants the government to bail out irresponsible bankers. The question is how to structure and monitor the financial system to minimize the risk of the devastating crises that make bailouts inevitable.

Is splitting up financial behemoths the best way to minimize that risk? Some reformers think so. So do the small but well-organized “community banks” that tend to get their way on Capitol Hill. “This isn’t a left-wing solution,” Sherman told me. “Most banks endorse it!” They would, wouldn’t they? There are about 6,800 banks in the U.S., and most of them would love to see the government take a hatchet to their largest competitors. Here are some points they rarely mention:

It’s a radical solution. The United States government does not normally cap the size of private firms, even gigantic firms like Apple or Wal-Mart. Who would invest in a company that’s legally prohibited from growing? It makes sense that Sanders, who is running for president as a critic of capitalism, would support such heavy-handed interference with the market economy. But it’s odd to see less extreme politicians support such extreme measures. They say they’re determined to eradicate too-big-to-fail—as well as “moral hazard,” the temptation for a too-big-to-fail bank to take excessive risks when it can rely on a government bailout if things go wrong. But have they gamed out what that would mean?

Put it this way: Bear Stearns wasn’t even one of the fifteen largest U.S. financial institutions in March 2008, when the Fed had to engineer a massive rescue to prevent it from collapsing and dragging down the global economy with it. Lehman Brothers wasn’t even in America’s top ten when its failure did trigger a global meltdown that September. Today, with over $2.5 trillion in assets, JP Morgan Chase is about eight times larger than Bear was when it was deemed too big to fail, so it would presumably have to be split into at least nine firms to get small enough to fail. Bank of America’s CEO recently noted that if it were forced to spin off some of its divisions, like investment banking and retail branches, each of the spun-off companies would still be “systemically important,” banker jargon for too big to fail.

Sanders announced his breakup bill at an early May news conference, saying "three of the four largest financial institutions in this country are 80 percent larger than they were in September 2007.” | Getty | Getty

The point is that tearing financial giants down to size—to what size, no one seems to know—would be a staggering logistical challenge. The bare-bones Sanders bill, just four pages in all, makes no effort to grapple with that challenge. It simply directs the Treasury Secretary to identify systemically important firms and somehow break them up. It’s a pretty blasé approach to restructuring America’s financial sector, which does, after all, sluice oceans of capital into productive enterprises, while employing 6 million people and accounting for nearly one-tenth of our GDP.

It’s a costly solution. There’s much to dislike about America’s financial sector, but it is America’s financial sector. It’s actually much smaller as a percentage of the economy than its counterparts in Asia and Europe, and it’s much less concentrated at the top . Unilaterally enforcing size limits on domestic banks would put the U.S. at a real competitive disadvantage in financial services.

That may not tug at anyone’s heartstrings, but not all of those 6 million Americans who work for our financial sector are wealthy financiers. They’re also tellers, loan officers, secretaries, security guards, janitors. And even those wealthy financiers pay U.S. taxes that help pay for our roads, our military and our health care. The fact is, If Uncle Sam breaks up JP Morgan Chase—the world’s sixth-largest bank, and the only U.S. bank in the top ten—its largest clients would presumably move their business to huge foreign banks that could still provide one-stop shopping for a variety of global services. Community banks can’t finance global megaprojects and megamergers. JP Morgan enjoys economies of scale just like Amazon and Home Depot do. We should acknowledge that imposing costs on U.S. banks could impose costs on U.S. companies and consumers, making credit less accessible and more expensive while increasing our trade deficit.

Needless to say, those costs would pale in comparison to the horrific pain inflicted by the implosion of 2008. Breaking up U.S. banks would be a radical policy, and it would damage a U.S. industry, but it would be well worth the trouble if it would also make the financial system safe.

There’s just no reason to think it would do that.

Megabanks aren’t necessarily the enemy of stability. At an early May news conference announcing his breakup bill, Sanders cherry-picked a telling statistic: “Today, three of the four largest financial institutions in this country are 80 percent larger than they were in September 2007.” Set aside the obvious counterpoint that the fourth institution, Citigroup, is now significantly smaller than it was in September 2007. What could possibly explain the growth of the other three?

Today, three of the four largest financial institutions in this country are 80 percent larger than they were in September 2007.

Sen. Bernie Sanders

Oh, I remember. They swallowed smaller too-big-to-fail banks that were failing during the height of the crisis, preventing a financial calamity from becoming a financial apocalypse. Government officials begged them to assume the obligations of their dying competitors to help stabilize the system during a panic, and they agreed, sometimes with government help, sometimes without it. If JP Morgan hadn’t been big and strong enough to absorb the hemorrhaging balance sheets of Bear Stearns and Washington Mutual, we might well have endured a depression. Ditto if Wells Fargo hadn’t been big and strong enough to let Wachovia collapse into its arms. The world is also lucky Bank of America was big and (arguably) dumb enough to salvage Countrywide and Merrill Lynch from the jaws of death.

That’s how those big three got even bigger—by helping to save the world through shotgun marriages with toxic partners. Sherman told me that while it may have been convenient to have sharks like JP Morgan and Bank of America around to swallow dying barracudas like Bear and Merrill, sharks wouldn’t have been needed in an ocean full of unthreatening flounder and carp. That may be true, but it’s a shame there wasn’t another shark around with available cash when Lehman Brothers needed a buyer. We might have avoided the Great Recession as well as Depression 2.0.

Of course, bigness is not an unalloyed plus for financial stability. By definition, too-big-to-fail banks can pose a threat to the system. My point is just that bigness is not an unalloyed minus for stability, either. There was another example in 2012 with the so-called London Whale fiasco, when a rogue JP Morgan trader lost more than $6 billion on unauthorized bets. That kind of debacle could have destroyed a smaller firm, even a Bear-sized firm with systemic implications, but for JP Morgan it merely depressed profits.

By the same token, smallness is no guarantee of stability. It was a flurry of relatively small bank failures that launched the Great Depression. Before the recent crisis, many of the flounder and carp of Sherman’s analogy were even more reliant on sketchy real estate loans than Wall Street’s sharks were. And while mega-rescues for mega-banks dominated the headlines, over 900 community banks and regional banks received bailouts through the Troubled Asset Relief Program as well. The government also guaranteed unsecured bank debt, money market funds, and deposits of up to $250,000, which amounted to an even more generous bailout of Main Street banks. If moral hazard is a problem, it’s not just a problem of bigness. It’s not even clear how pervasive a problem it was before the crisis; the government had never provided aid to an investment bank before 2008, so Bear and Lehman had no reasonable expectations of bailouts when they were getting into their messes.

Nevertheless, for many Americans, the lesson of the crisis was the danger of size. That’s why populist politicians want to break up big banks. That’s also why they want to reinstate the Glass-Steagall rules separating commercial banks from securities firms, even though Bear, Lehman, Merrill, Fannie Mae, Freddie Mac, AIG and the other firms at the heart of the crisis were totally unaffected by Glass-Steagall. Megabanks just seem scary.

They can be scary. But the main cause of hellacious crises is not overlarge banks. It’s overleveraged banks that make risky bets with borrowed money. Before the panic of 2008, the financial system had a risk problem, not a size problem. The U.S. and international responses to the crisis, quite sensibly, have focused on risk.

Reform is already working. The best way to prevent banks from imploding is to make sure they have enough capital to absorb potential losses. In other words, regulators should rein in leverage, which is basically the opposite of capital. This is vital for all banks, but especially for the biggest, which pose the biggest systemic threat when their bets go bad. They also tend to enjoy lower borrowing rates based on expectations that the government will bail them out of trouble, the so-called too-big-to-fail subsidy.

Guess what? The main thrust of America’s Dodd-Frank financial reforms and the world’s Basel 3 regulations has been to limit leverage and force banks to hold more capital. The capital requirements get progressively tougher as banks get bigger, essentially a tax on bigness. And they’re working. The big banks are better-capitalized and less dependent on overnight financing that can vanish in a crisis. Giants like AIG and Goldman Sachs that once escaped serious regulation because they weren’t considered commercial banks are now subject to close scrutiny by the Fed and a new Treasury-led Financial Stability Oversight Committee. That’s why General Electric is selling its finance arm, GE Capital. Big financial institutions can’t hide in the shadows anymore. They must also draw up detailed “living wills,” blueprints for how they could be dismantled with minimal chaos if they ever collapsed.

Americans are often warned that Wall Street controls Washington, but the megabanks took a beating in Dodd-Frank; the community banks, which have a presence in every congressional district, wield more power on the Hill, and fared much better. The best evidence came from a Government Accountability Office analysis of the too-big-to-fail subsidy. The GAO ran bond-market data through 42 economic models and reached conclusions that the congressional break-up-the-banks crowd didn’t expect when it requested the analysis. The too-big-to-fail funding advantage had declined dramatically since the crisis, and in many models, the subsidy had vanished completely. It’s still tough to imagine the government letting a true giant fold during a 2008-style general panic, but it’s at least conceivable in a generally stable time like today.

This does not necessarily mean the work of reform is done. Maybe the capital rules should be even tougher. Maybe the penalties for bigness should be even steeper. Maybe there should be stricter reforms of executive salaries and bonuses, or more tax hikes for top earners, or some version of the tax on financial transactions that Sanders also supports. But before we impose an arbitrary, say, $250 billion cap on bank assets, we should be sure a world where the U.S. (but no other country) has a slew of banks with $249.9 billion in assets would be a much safer world. And we should have some humility about our ability to extinguish risk from an inherently risky business.

In retrospect, America’s pre-crisis regulations for commercial banks like JP Morgan and Citi were clearly too weak. But they were strong enough to drive trillions of dollars worth of risky assets into the less regulated “shadow banking system”—investment banks like Bear and Lehman, government-sponsored enterprises like Fannie and Freddie, and insurers like AIG, not to mention off-balance-sheet vehicles that commercial banks like Citi used to dodge their regulatory constraints. Risk has a way of migrating to the path of least resistance; Geithner likes to compare it to a river finding its way around stones. The post-crisis reforms significantly broadened the scope of financial regulation, especially for large institutions, but it’s hard to predict where risk will migrate next. It would be even harder to predict what radically restructuring the industry would do to risk.

What’s safe to predict is that risk won’t go away. The goal should be to monitor and manage it, not to eradicate it. Financial reformers often make grand pronouncements about how this or that reform will eliminate the risk of meltdowns and bailouts, but those risks will remain as long as human beings are susceptible to manias like the one that inflated the credit bubble before the crisis and panics like the one that nearly shredded the system during the crisis—in other words, as long as human beings are human.

It’s probably a fair rule of thumb to refrain from rewriting the basic rules of capitalism unless you’re sure it’s absolutely necessary. Breaking up the big banks would inject tremendous turmoil into a confidence-based industry where turmoil can have far-reaching unintended consequences. And it wouldn’t prevent the next crisis. At best, it would make the next crisis look somewhat different than the last.



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