Breaking Up the Big Banks: Here’s How to Do It
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The Fiscal Times
January 13, 2014

A report expected later this year from the Government Accountability Office is expected to lend support to a growing movement aimed at reducing the size of the largest banks in the United States. Well before that report is released, though, advocates of breaking up the big banks have been busy readying proposals for just how to make that happen. 

The proposals continue to mount because of widespread concern that the actions taken by the federal government in the wake of the financial crisis, including a legal prohibition on bank bailouts and a partial ban on banks trading securities, simply aren’t enough to prevent the need for another round of bailouts should there be a crisis. 

Related: Why ‘Too Big to Fail’ Is a Bigger Problem Than Ever

At a hearing of the Senate Banking Committee’s Subcommittee on Financial Institutions and Consumer Protection last week, some of the leading contenders were discussed. 

The Dallas Fed’s Plan
Harvey Rosenblum, a 40-year veteran of the Federal Reserve System who now teaches at Southern Methodist University and helped author a plan touted by the Federal Reserve Bank of Dallas, illustrated the danger huge financial institutions pose to the overall economy by citing a paper published by the Dallas Fed that found the financial crisis will, in the end, cost the U.S. economy between $10 trillion and $30 trillion in lost output.

“This is one-to-two years of U.S. output down the drain,” he said. “Allow me to translate this into everyday language the average person can understand: a conservative estimate is that the crisis cost $50,000 to $120,000 for every U.S. household.” 

The Dallas Fed plan to reduce the economy’s exposure to the biggest banks has three parts. First, it would explicitly restrict the government’s “guarantee” to assets already protected by the Federal Deposit Insurance Corporation – i.e., bank deposits – and it would eliminate access by the non-depository elements of a big bank to Federal Reserve loans. Second, it would require any company or individual doing business with a large bank to sign a declaration stating that they understand there is no federal guarantee.

Finally, it would direct federal bank regulators to create incentives for banks to “streamline, simplify and downsize their companies so that any and all banking affiliates of the financial holding company would be certified by the FDIC as ‘Too Small to Save’ in the event of failure.”

Related: Why Jack Lew Is Kidding Himself About ‘Too Big to Fail’

While the Dallas Fed plan has received significant attention from lawmakers, some observers are concerned that in the event of a crisis, the Federal Reserve and the Treasury Department would still have every reason to step in and protect a big bank. After all, they argue, the reason for the bailouts in 2008 and 2009 was not to protect depositors and counterparties, but to prevent a broad economic meltdown.

The Subsidy Reserve Plan
Professor Cornelius Hurley, director of the Boston University Center for Finance, Law and Policy, has put forward an alternative, called the Subsidy Reserve Plan, which was introduced last year as legislation by House Banking Committee member Rep. Michael Capuano (D-MA).

Under the Hurley plan, the Federal Reserve and the Office of Financial Research would be required to put a dollar value on the subsidy large banks receive each year, and the banks would be required to hold that amount of money on their balance sheets as a reserve, adding to it each year according to the size of the subsidy it receives.

The GAO report due later this year will place a value on that implicit subsidy created by the widespread perception that they are “too big to fail”, a perception cemented by the bailout of the banking system during the financial crisis. The subsidy comes in the form of lower interest rates, because bondholders and other lenders assume that their investments have an extra level of protection because the government can’t afford to let one of the big banks fail and take the rest of the economy with it. 

Related: How Dodd-Frank Shifted the Risk Instead of Burying It

It’s unclear how large the GAO will determine the subsidy to be, but estimates have already been made by outside experts. The Bank for International Settlements in Basel, Switzerland – a sort of international bank regulatory body – and the International Monetary Fund have both estimated the amount big banks receive from taxpayers, and the amount consistently comes in between $50 billion and $100 billion per year.

The added reserves required by Hurley’s plan would not count toward the amount of capital the bank is required to hold by regulation, but would be counted separately. “The only way they can monetize the reserve is by divesting themselves of assets,” Hurley explained in an interview. “As they downsize, the pro rata portion of the reserve is allocated to the assets being divested.”

In theory, Hurley said, the largest banks, by carrying this increasing reserve on their balance sheets, will eventually become “so bloated that they are not too big to fail because they are, in effect, overcapitalized.”

In reality, he said, shareholders would never allow a bank to carry such a large amount of unproductive capital on its books, and market forces would cause the institutions to downsize to the point at which they no longer receive the subsidy. 

Related: Key U.S. Regulator Too Cozy with Big Banks – Report

Hurley’s plan shares some characteristics with a proposal put forward by Sen. Sherrod Brown (D-OH) and Sen. David Vitter (R-LA), which would set onerous capital levels for large banks but does not break out subsidy-related capital as an independent item.

A Return to Glass-Steagall
Finally, there is the proposal introduced by Sen. Elizabeth Warren (D-Mass.) that would, in effect, repeal large segments of the Gramm-Leach-Bliley Act. That law, passed in 1999, undid the generations-old Glass-Steagall Act’s prohibition on mixing banking and commercial activity such as securities trading and insurance sales.

Many view Gramm-Leach-Bliley as the root cause of the financial crisis, because it allowed banks to engage in riskier activities. Warren and others in the Senate have proposed a “21st Century Glass-Steagall Act” that would force the largest banks to divest themselves of business lines engaged in non-banking activities.

Follow Rob Garver on Twitter: @rrgarver

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A longtime reporter on the intersection of the federal government and the private sector, Rob Garver is National Correspondent, based in Washington, D.C. He has written for ProPublica, The New York Times and other publications.