Legislation coming to break up big banks?

November 5, 2009

In a note to clients yesterday, Paul Miller of FBR Capital Markets wrote:

We are hearing that discussion of breaking up large financial institutions that pose systemic risk to the market is gaining traction on the Hill. At this point, discussions are in the early stages, but we understand that an amendment addressing breaking up institutions deemed “too big to fail” could be introduced in the House over the next few days. How does one define “too big to fail” and how would the divestiture process work – these are good questions that Congress will have to address as the discussion moves forward. To our understanding, any amendment that could be introduced in the coming week would likely be vague and would give the regulators discretion to determine which institutions qualify as “too big” and how to address the risk they pose to the system.

[UPDATE: It appears this legislation may be coming from PA's Paul Kanjorski]

Hmmm. A “vague” amendment directing regulators to look into breaking up TBTF banks might not lead to much, not when regulators have made clear they have no interest in breaking up big banks.

[After she gave a speech complaining about TBTF at the Economist's Buttonwood Conference, I asked Sheila Bair if she would favor policies to proactively shrink/break up big banks. She said "no, I don't know how we would do that."]

And breaking up banks is only half the battle. While it’s very important to get commercial banks out of the trading business, if derivative books don’t shrink dramatically systemic risk won’t have gone away.

Neither Bear nor Lehman had a commercial bank. But the size, opacity and interconnectedness of their trading books posed huge risks for the system.

Speaking of the systemic risk posed by derivative books, there’s a very interesting and relevant tidbit in Andrew Ross Sorkin’s new book titled “Too Big to Fail.”

Not long before AIG collapsed, CEO Bob Willumstad went to Tim Geithner — then head of the NY Fed — and asked that AIG be made a “primary dealer,” giving it access to the Fed as its lender of last resort….

He left Geithner with two documents. One was a fact sheet that listed all the attributes of AIG FP [the division run by Joe Cassano that blew the company up] and argued why it should be given status as a primary dealer. The other–a bombshell that Willumstad was confident would draw Geithner’s attention–was a report on AIG’s counterparty exposure around the world, which included “2.7 trillion of notional derivative exposures, with 12,000 individual contracts.” About halfway down the page, in bold, was the detail that Willumstad hoped would strike Geithner as startling: “$1 trillion of exposures concentrated with 12 major financial institutions.”

You will bail me out or I’ll bring the whole system down with me.

Until they neuter the derivatives business by putting all contracts on exchanges, enhanced “resolution authority” will probably be meaningless. Regulators still won’t be able to shutter the largest financials because doing so would cause the systemic event they’re trying to avoid in the first place.


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I wonder if a workable answer to Bair’s comment about not knowing how to break up TBTFs is to set criteria (asset size, Glass-Steagall-like limits, whatever) and let the banks figure out how to downsize themselves so as to meet the criteria.

Posted by LH | Report as abusive

This idea that CDS and other derivatives work like a physics equation or a string of firecrackers is nonsense. It IS possible to say “we don’t have your cash right now,” or “no, that doesn’t count as a default,” or “let’s renegotiate because it beats getting nothing,” etc. I know the Fed and Treasury claim they’re not competent to handle it, but why is virtually no one talking (publicly) about how to unwind these positions, either by fiat (e.g. change in BK law, or some other measure covering derivatives in non-BK situations) or through negotiation? At some point, someone is going to have to just say “tough” on derivatives and associated collateral calls. I know Geithner believes the entire world will come to an end if CDS aren’t paid out at 100 cents on the dollar, but refusing to write down the value of credit (of all types) doesn’t change reality. All we’re doing is passing that credit risk on to the taxpayer, without extracting any pain from the responsible parties. The alternatives might result in bond defaults and a hit to pension funds and insurance companies, but SOMEONE is going to have to take the hit. And there’s no good reason why taxpayers in general should take that hit instead of particular banks, their bondholders, and the companies and funds that hold those bonds. I think Geithner just fundamentally misunderstands the mathematical and economic realities at work here — he really believes that if they can just hold the thing together long enough, it will all work out fine.

“trigger a systemic event” is not always true. The legislature could declare such contract clauses are unenforceable as is done in many other areas of law. Likewise would be a good idea for CDS which do not demand the return of the defaulted asset, and prohibit the CDS reuse of such as asset.

Posted by Rick Dean | Report as abusive

The financial crisis was a result of poor internal operations models that have not been repaired, these operational dysfunctions are more prevelant in larger institutions. There is no need to legislate the break up of large institutions as they will begin to disintigrate on their own whenever the next shoe drops and there is not an extra 4 trillion lying around to support their balance sheets.

Citigroup is looking at writing down 39 billion and Goldman Sachs is taking home a 20 billion dollar bonus year. The market is a Win/Lose Game and when such large institutions are enabled to play the Win/Lose Game with unlimited Federal Funds (which are in fact, not unlimited), then ultimately the pressure on the losers will cause an irreconcilable financial loss to the support mechanism.

They do not need to regulate the size of the institution but regulate the size of the TRADING POSITIONS of any one institution and its related entities.

This will cause a natural divestiture of TBTF’s into smaller enterprizes that can war with each other for trading profits without causing the extreme damage to the countries core that is done lately.

Regulating Proprietary Trading Positions of Commercial Banks is the answer.

This will reduce systemic risk while not reducing service delivery to customers.

Sure, they’ll complain but hey, glad its not my job.