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If big U.S. banks are not forced to sever their investment arms from traditional banking, they will return to behavior that led to the 2008 credit crisis, said Federal Deposit Insurance Corp. board member Thomas Hoenig.

“The behavior and practices leading to this crisis will soon reemerge and these highly complex, more vulnerable firms will have an even more devastating effect on the economy,” Hoenig said in remarks yesterday at the Exchequer Club in Washington. “Activities leading to the crisis continue today -- and continue to be subsidized -- well after the lessons should have been learned.”

Regulators should reinstate a separation between commercial banking and brokerages, a kind of “modern version” of the Glass-Steagall Act to separate commercial banking from brokerage operations, Hoenig has argued since before joining the FDIC in April. The public safety net should not protect the banking industry’s trading risks, according to the former Federal Reserve Bank of Kansas City president.

Hoenig said major banks have “misled the markets regarding interest rates” and that “firms using FDIC-insured funds continue to make directional bets on asset values and global events.”

He said the 2010 Dodd-Frank Act and its so-called Volcker rule to ban banks from proprietary trading was insufficient and that the government safety net will still cover swaps trading and market making, “much of which could become veiled prop-trading.”

Big Banks

The big banks won’t “come along willingly” but should be forced to, Hoenig said.

“It is alarming that CEOs of some financial firms fail to grasp why they are trusted so little nor appreciate the reputational damage they caused their industry,” he said.

Last week, Hoenig said capital rules revised by the Basel Committee on Banking Supervision should be replaced by a simpler leverage ratio. Basel’s U.S. implementation should be delayed, he said, and risk should instead be reduced with leverage ratio requirements.

Asked yesterday if tighter leverage rules and his proposal to split up complex banking operations could drive business into a so-called shadow banking system, he said his ideas would instead create a system in which capital demands would be clearer and the market would be more aware of its responsibilities.

“Yes, firms would fail, and yes, there will be disruptions from that, but it would not bring the entire world down,” Hoenig said.