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Breaking up banks is easy when they aren’t failing

If we decide to break up the big banks, can we actually do it?

The first and most obvious proof that we can lies in the 2010 bank-regulation law, the Dodd-Frank Act, which requires America’s too-big-to-fail banks to submit plans — so-called living wills — outlining how they can be dismantled if they get into trouble. So these banks have already provided breakup blueprints.

All that is required is to remove the conditionality and change the timing: Break them up now, not when and if. And what could be easier than doing so according to their own instructions, and so, once and for all, eliminate the systemic risk posed by the biggest and riskiest banks?

Second, it has been done before. After the passage of the Glass-Steagall Act of 1933, big banks were divided into separate commercial-banking and investment-banking institutions.

Nevertheless, there is a vague notion hanging over the public debate that suggests the U.S.’s big banks are too complex to pull apart.

So, let’s get more technical and look at the balance sheets of the three biggest U.S. lenders: JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc., each of which holds roughly $2 trillion in assets, and together account for about half of bank-industry assets. Their loan portfolios make up 30 percent to 40 percent of their total assets. Four categories account for most of their loans — credit cards, home mortgages, commercial mortgages and businesses.

Stand Alone

First, a general rule of thumb: These big banks house many businesses that can stand alone. Take credit-card lending, which a company such as American Express Co. conducts as its main line of business. There is no reason banks couldn’t sell or spin off all of their credit-card operations.

Of course, selling assets rather than an entire business is another way to reduce the size of a bank. For instance, last May HSBC Holdings Plc, the U.K.’s largest bank, closed the sale of its $30 billion U.S. credit-card loan portfolio to Capital One Financial Corp., a large U.S. bank (though not a megabank). HSBC booked a $2.4 billion after-tax profit on the sale, both reducing assets and increasing capital and contributing to the improved strength of HSBC.

Another simple rule: Assets originated, or produced, by a bank need not be retained and owned by the bank. Most Americans know this as the unfortunate result of the financial crisis that was caused largely by big banks selling home mortgages in esoteric securitized forms — those infamous subprime collateralized-debt obligations. For decades before, banks sold mortgages in less-risky formats, and they still can. The megabanks could sell mortgages, both in big one-time sales to downsize and, thereafter, continuously, originating more for sale than to hold, in order to limit growth.

In commercial-real-estate and business lending, big banks typically syndicate newly originated large loans, retaining ownership of only a portion of the loan and parceling out shares of it to other, typically smaller, banks.

So, as part of a breakup plan, our megabanks could easily sell loans of all kinds without changing their consumer and corporate marketing-and-lending strategies or their overall business models in any fundamental way.

Now, what constitutes the rest of these megabanks’ assets? From 40 percent to 60 percent of their assets reside in their capital-markets divisions, whose activities fall into three broad categories.

First, all banks must maintain liquidity, so they hold cash and various highly liquid securities.

Second, all banks hold investment securities, including large amounts of U.S. Treasuries and mortgage-backed securities. These, too, can be sold with ease to reduce size.

Trading Accounts

Third, the three megabanks maintain huge trading operations; at any given time, each holds $200 billion to $450 billion, or 10 to 20 percent of their total assets, in trading accounts made up of marketable debt and equity securities and derivatives. Most of the securities can be sold easily.

Other assets could be divested in order to separate lower-risk trading that is typical of most commercial banks from riskier types of trading that the Dodd-Frank Act’s unfinished Volcker rule attempts to limit.

Such a separation would focus heavily on derivatives, which aren’t debt or equity securities, but rather contracts whose value is derived from securities, currencies, loans or commodities. Most derivatives are straightforward, predominantly swaps of a fixed-interest-rate obligation for a variable rate (or vice versa). But many derivatives are esoteric, unique and not easily sold.

The three largest megabanks, along with Goldman Sachs Group Inc., control more than 90 percent of the U.S. derivatives market. Their breakup would have the additional benefit of diversifying a dangerously overconcentrated market. This would take time, as other market participants got up to speed and existing derivatives positions were unwound.

Of course, if the asset side of the balance sheet is reduced, then the liability side must contract, as well.

All three megabanks raise funds equal to about 20 percent of assets through short-term borrowing in the capital markets. This easily could be reduced because the need for these funds declines as assets are sold or divested.

To reduce liabilities further, the megabanks would need to decrease their deposits, which equal about 50 percent of assets.

Well, how? Shedding deposits isn’t too hard. Deposits are sold all the time in very simple and straightforward transactions when a bank sells one or more branch offices to another bank. The deposit liabilities are sold by coupling them with a package of assets, such as loans or securities, acceptable to the purchasing bank.

Branches are usually sold at a profit. For example, last May, HSBC closed the sale of with $15 billion in deposits in northern New York state to a small bank, First Niagara Financial Group Inc. HSBC booked a $1 billion profit on the sale. Again, HSBC enjoyed a double-barrel enhancement of its financial strength.

So, balance-sheet analysis demonstrates that shrinking megabanks would be easy, except in the one circumstance where a breakup is mandated under current regulatory policy — when a financial crisis is looming or upon us. Living wills are unlikely to work when markets are freezing up, buyers are disappearing, asset values are in doubt and panic is in the air.

If we are ever going to break up the megabanks, the time is now, in today’s relatively stable environment. Doing so wouldn’t be difficult or painful. Breaking up is easy to do.

As appeared in Bloomberg on Jan. 6, 2013.


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