A major, if perhaps unintended, consequence of the Treasury systemic-risk resolution bill
would be to make still more firms big enough to pose systemic risk. This results from the
blank check given the FDIC to provide any form of direct or indirect aid to a systemic-
risk institution – aid that would lead either to sustenance for the unresolved systemic-risk
firm or subsidized mergers (the FDIC’s current resolution preference for big boys). This
is so perverse a result that we hope Treasury doesn’t mean it. In fact, we expect the next
iteration of the resolution regime, possibly in tandem with the missing systemic-risk
regulatory framework, to lay out a process in which big firms are divvied up and returned
to more manageable constituent parts.

Let’s first address why we think plans are afoot to break up big financial firms and then
address just how this could be done. Some of our analysis is, to be sure, hopeful – we’ve
long been troubled by the regulators’ penchant for consolidation as a supervisory
response. Now, though, discussions with senior regulators lead us to believe that the
precipitous collapse of the industry in the fourth quarter was an epiphanal event. At least
some policy-makers are quietly questioning the deals that got done then with such
disastrous results now. Atop this is the G-30 report, which clearly points to the problems
of diversified, colossal firms and it’s been required reading for all of the Obama
Administration’s senior policy-makers – or at least those who need to read it now because
they didn’t write it last year.

Importantly, the Bank of England is apparently considering a break-up of the U.K.’s
diversified banks into components focusing on commercial and investment banking. The
head of the BoE is a close confidant of the FRB chairman, but – even if he weren’t – the
FRB has long harbored fears about commingling divergent banking businesses. Clients
of a certain age will recall the reluctance with which the FRB was dragged into relaxing
the barriers mandated by the Glass-Steagall Act, with the Board doing so very gradually
over almost twenty years before Congress formalized this in the Gramm-Leach-Bliley
Act of 1999. Even then, though, the FRB refused to go as far as the industry wanted,
resulting in the compromise, holding-company approach to financial firms instead of the
all-in approach favored by the OCC at the behest of the biggest national banks.

Now, many at the Fed find their fears validated and are looking at ways to deconstruct
financial holding companies. In contrast to the BoE, the FRB doesn’t have a ready way
to do so because – at least so far – the U.S. doesn’t own majority stakes in the biggest
banks, as has sadly become the fate of the U.K.’s banks. However, the new systemic-risk
debate gives the FRB a multi-step way to force big financial holding companies to see the
error of their ways.

How to do this? First, implement one policy already advocated by the former head of the
New York Fed now housed at Treasury: mandate higher capital, risk-management and
other standards for any institution that trips the systemic-risk alarm. As a result, any
very, very big firm by definition will be less profitable than smaller competitors because,
all things being equal, its return on equity will always be less. This will quickly lead to
strategic divestitures in hopes of slimming down the biggest firms or, at the least
minimizing their added cost.

Next up will be a host of new rules designed to undo the conflicts of interest embedded in
financial holding companies allowed to be on both sides of all too many transactions in
recent years. Competitors to the big firms tried vainly to push these as deregulation was
all the rage. Now that it isn’t, these proposals will gain new force and, we think, find far
more sympathy at the FRB and other agencies.

And, if regulators remain recalcitrant – which we doubt – Congress is readying for a full-
court press on too-big-to-fail banks. It’s too early to handicap the chances for a real
rewrite of GLBA, but at the least, it’s a potent proposal with major advocates on both
sides of the aisle holding big gavels. We expect Congress will find it far harder by law to
break apart the intertwined businesses of commercial and investment banking than
reformers now think. However, by the time they realize this, the industry may have done
much of the hard work for them by ungluing huge conglomerates because of irresistible
regulatory forces propelled by changing global financial markets..