JPMorgan’s Blunder Doesn’t Mean U.S. Should Bust Up Banks

May 23 (Bloomberg) -- JPMorgan Chase & Co.’s colossal $3 billion-and-counting trading blunder has breathed new life into long-simmering calls to break up big U.S. banks. We agree they’ve become too concentrated, too complex and too unwieldy to effectively regulate or manage, but there are better solutions than asking bureaucrats to take them apart.

The biggest U.S. banks have grown only bigger since the financial crisis. The five largest institutions now control 52 percent of all the banking industry’s assets, up from 17 percent in 1970. JPMorgan alone holds more than $2.3 trillion, up from $1.6 trillion in 2008. The banks’ size is partly the result of a perverse incentive: The larger and more systemically threatening they become, the more likely the government will be to bail them out in an emergency. That too-big-to-fail status gives them an advantage in the marketplace, allowing them to borrow more cheaply than smaller, less dangerous banks. They commonly use that taxpayer-subsidized money to make speculative bets, like the one that went sour at JPMorgan.

Opposition to this state of affairs has intensified recently, as prominent voices -- including Federal Reserve Bank of Dallas President Richard Fisher, St. Louis Fed President James Bullard and former Federal Deposit Insurance Corp. Chairman Sheila Bair -- have called for shrinking U.S. banks. Splitting the businesses of traditional lending and risky trading into separate entities, the argument goes, would minimize the threat of another financial crisis, protect taxpayers and bank customers, and better insulate the U.S. economy against shocks. The debate over whether this would be the right approach crosses partisan lines: Neither President Barack Obama nor presumptive Republican nominee Mitt Romney, for example, is in the break-up-the-banks camp.

Market Roulette

Undoubtedly, there is good reason to be worried about the dangers posed by superbanks that take depositor money with one hand while playing market roulette with the other. A big enough mistake on the roulette side -- where traders buy and sell securities such as credit default swaps and collateralized debt obligations -- can impair a bank’s lending capacity or even cripple an entire institution.

Despite the best efforts of the Dodd-Frank financial reform legislation, it’s still not hard to envision a situation where the government would need to ride to the rescue of a JPMorgan, Bank of America Corp. or Wells Fargo & Co. to prevent broader contagion. The law requires more transparent trading of derivatives, stepped-up oversight of systemically important institutions and more capital to absorb losses. It gives regulators the power to take apart a large, failing institution if it’s a threat to the financial system, and creates significant hurdles for any future taxpayer bailout. In the yet-to-be-implemented Volcker rule, it seeks to forbid banks from speculating for profit with their own money. Nonetheless, credit-rating companies Standard & Poor’s and Moody’s Investors Service both say they anticipate the U.S. government would rescue large banks in a future crisis, and the banks’ borrowing costs suggest the market agrees.

It’s tempting to consider a return to the days of the Glass-Steagall Act, when institutions engaged either in traditional banking -- taking customer deposits and lending -- or securities trading. Unfortunately, that’s not likely to work. The financial system has evolved in some irreversible ways. It’s increasingly hard to differentiate between securities and loans, because the latter are now often written as contracts that can be traded. Many loan commitments must be considered derivatives for accounting reasons. Perhaps most important, the responsibility for making such difficult distinctions would fall to Washington, which has proved time and again its inability to assess risk. As the experience of Lehman Brothers Holdings Inc. demonstrated, even a pure securities firm can present a big threat to the system.

Penalize Bigness

A better approach would be to change the economic incentives. Make bigness more costly, rather than more rewarding. There are various ways to achieve this. Regulators can impose fees tied to the size of banks’ liabilities or to their reliance on fickle short-term financing, which tends to disappear in a crisis. Capital requirements for the largest banks can be raised far higher than the 7 percent the Fed currently requires. Research by economists at the Bank of England suggests 20 percent would be the optimal level for economic growth. Beyond that, regulators can require bank holding companies to capitalize their lending and trading operations separately, so that losses in one business won’t affect the other; this “ring-fencing” approach is already being put in place in the U.K.

Don’t count on the banks to be happy with increased capital requirements and risk-based fees. JPMorgan Chief Executive Officer Jamie Dimon, for instance, has argued that such requirements will crimp lending and harm the broader economy. We’ve debunked that fallacy before. Bank executives’ real concern is that they will lose a taxpayer subsidy that has made it easy to boost their profits and bonuses in good times.

U.S. taxpayers should never again have to worry that a bank’s missteps will threaten economic disaster and necessitate a bailout. Giving banks an incentive to shrink will go a long way toward protecting the financial system and making too big to fail a thing of the past.

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