Calls by former Citigroup Inc. CEO Sanford Weill and others to break up the big banks reflect lingering public fear and anger toward financial institutions that seem too big to fail.
These calls, however, ignore the unintended consequences of making our global banks too small to succeed: Much of the business will migrate to non-U.S. banks and the less-regulated shadow banking sector. Weill and the rest also neglect to consider key reforms that protect taxpayers from a potential failure.
In a global economy, there is a need for financial institutions with scale and global capacity. Large banks offer their customers products, services and infrastructure that smaller banks cannot match, from multicity branch networks to global coverage that lowers costs. Philadelphia-based chemical company FMC Corp., for example, relies on large banks to fund its $1.5 billion revolving credit line and to offer worldwide support for its financing needs.
The global transaction services that big banks provide to governments, multinational corporations and institutions simply couldn’t be replicated as efficiently or as cheaply by smaller banks, or even a patchwork of smaller ones. As JPMorgan Chase & Co. CEO Jamie Dimon recently pointed out, it takes a certain scale to offer a $5 billion credit line.
Too-big-to-fail is a serious issue, but there has been more progress on this front than is widely understood. The orderly liquidation authority in the 2010 Dodd-Frank financial-reform law means that large banks can and will be allowed to fail in the future. Dodd-Frank allows the Federal Deposit Insurance Corp. to keep a failing bank running, but shareholders will be wiped out and bondholders, not taxpayers, will cover any government losses.
The law prohibits bondholders from receiving a taxpayer bailout and instead requires them to take “haircuts.” This means that investors thinking of providing funding to a risky bank know in advance that they will take losses if things go bad. This reverses the previous advantage of large banks in obtaining low-cost funding from investors who expected to be made whole from a government bailout.