Oct. 15 (Bloomberg) -- U.S. regulators should consider breaking up large financial institutions considered “too big to fail,” former Federal Reserve Chairman Alan Greenspan said.

Those banks have an implicit subsidy allowing them to borrow at lower cost because lenders believe the government will always step in to guarantee their obligations. That squeezes out competition and creates a danger to the financial system, Greenspan told the Council on Foreign Relations in New York.

“If they’re too big to fail, they’re too big,” Greenspan said today. “In 1911 we broke up Standard Oil -- so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”

At one point, no bank was considered too big to fail, Greenspan said. That changed after the Treasury Department under then-Secretary Hank Paulson effectively nationalized Fannie Mae and Freddie Mac, and the Treasury and Fed bailed out Bear Stearns Cos. and American International Group Inc.

“It’s going to be very difficult to repair their credibility on that because when push came to shove, they didn’t stand up,” Greenspan said.

Fed officials have suggested imposing a tax or requiring higher capital ratios on larger banks to ensure the firms’ safety and reduce some of the competitive advantage from the implied subsidy. Greenspan said that won’t work.

“I don’t think merely raising the fees or capital on large institutions or taxing them is enough,” Greenspan said. “I think they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll still be using the savings.”

‘Really Arbitrarily’

The former Fed chairman said while “just really arbitrarily breaking down organizations into various different sizes” goes against his philosophical leanings, something must be done to solve the too-big-to-fail issue.

“If you don’t neutralize that, you’re going to get a moribund group of obsolescent institutions which will be a big drain on the savings of the society,” he said.

“Failure is an integral part, a necessary part of a market system,” he said. “If you start focusing on those who should be shrinking, it undermines growing standards of living and can even bring them down.”

To contact the reporter on this story: Michael McKee in New York at mmckee@bloomberg.net; Scott Lanman in Washington at slanman@bloomberg.net

Last Updated: October 15, 2009 10:50 EDT