"The apologists of successful dishonesty always declaim against any effort to punish or prevent it on the ground that such effort will 'unsettle business.' It is they who by their acts have unsettled business ... But if it were true that to cut out rottenness from the body politic meant a momentary check to an unhealthy seeming prosperity, I should not for one moment hesitate to put the knife to the cancer."

Theodore Roosevelt wrote that in 1908, amid searing debate over breaking up John D. Rockefeller's oil trust, Standard Oil. Roosevelt was berated tirelessly in his quest to end the oil monopoly. Protesters said he was hurting business. He was ruining the oil industry. He was destroying wealth.

Standard Oil was eventually split up in 1911 under President Taft. Within two years, Rockefeller's net worth doubled, and the industry was in boom like never before. The Baby Standards were on fire. A new prayer emerged on Wall Street: "Oh Merciful Providence, give us another dissolution." The oil industry, as we now know, hasn't done too badly over the years.

The example isn't perfectly equivalent, but we're somewhere near where Teddy Roosevelt stood in 1908. A century ago, the oil monopoly's imposition on the economy involved anticompetive behavior. Today, the issue regards banks becoming too big to fail -- a far more dangerous situation. Yet the debate is just as nasty today as it was back then.

Banks get bigger and bigger
Just to give you an idea of the ridiculousness we're dealing with today, Simon Johnson and James Kwak, authors of 13 Bankers, have found that since 1995, assets controlled by the six largest banks have exploded from 17% of GDP to 63%.

































Source: 13 Bankers. All rights reserved.

 

We find this sickening -- and spectacularly dangerous to the economy. The next time one of these banks stumbles, it could take down the rest of our economy with it. Then Congress and whoever is President will have to make the impossible choice between bailouts and financial collapse.

Most of us agree that the bailouts of fall 2008 must never happen again. Yet letting a massive bank like Lehman Brothers simply disintegrate, while taking the entire economy with it, is not the answer, either. When the mistakes of a few people affect everyone, we've moved beyond free-market capitalism into economic carpet-bombing.

Adam Smith, the father of free-market thinking, agrees. So does the judge who oversaw Lehman's bankruptcy. Lehman's collapse "can never be deemed precedent for future cases. It's hard for me to imagine a similar emergency" said Judge James Peck.

We've had enough
Thankfully, we're now moving toward a more sensible system of financial failure, one that tries to escape the bailout-vs.-economic-ruin dilemma. The financial reform bill proposed by Sen. Christopher Dodd, now coming up for debate in the Senate, tries to address the issue with an alternative to bankruptcy known as "orderly liquidation."

Here's how it's supposed to work. When any financial company starts giving off the aroma of distress, the Dodd bill proposes that the government call upon a special dissolution team. The team will only spring into action if two-thirds of Federal Reserve Governors, two-thirds of the SEC, a special panel of Delaware Bankruptcy judges, and the Treasury Secretary (in consultation with the President) think the company in question is about to blow up.

If that ailing company's failure would wreck the economy, there's no private buyer for it, and bankruptcy's out of the question, the FDIC (or SIPC) would take over and liquidate its assets. Shareholders and creditors are supposed to bear all the losses, just like in a Chapter 7 bankruptcy. Management responsible for the failure gets canned. Basically, it would do for massive Frankenbanks what the FDIC already does for small banks when they fail.

This is a great start. We need a process to clean up and liquidate megabanks when they fail, so that the shock of bankruptcy doesn't jackknife our economy like Lehman Brothers did. The problem is that on its own, orderly liquidation doesn't solve the problem of "too big to fail." Someone would still need to absorb the massive losses such a failure could create. And while the bill makes it clear that somebody is supposed to be shareholders and creditors, if the size of those losses set off a ripple effect throughout the economy -- and they always do -- we'd still have a financial panic.

Imagine that we had liquidated AIG -- but instead of making taxpayers foot the $180 billion tab, the liquidation authority would most likely force AIG's creditors (Goldman Sachs, et al.) to eat that massive loss, in the midst of a hysterical market panic. Do you honestly imagine that wouldn't cause financial calamity? That's exactly the dilemma we faced in 2008. To be brief, the Dodd bill in itself doesn't end too big to fail, nor does it end the need for future taxpayer-funded bailouts.

That isn't just our opinion. A recent informal survey of experts -- Democrat and Republican -- conducted by NPR's PlanetMoney found exactly no one who thought the Dodd bill in its current form would end "too big to fail."

For any reform to be effective, we need rules that prevent banks from becoming so unwieldy that they can't be wound down without financial panic and taxpayer support. We need rules that end too big to fail.

Lucky us!
One promising idea put forth by Sens. Sherrod Brown and Ted Kaufman is the SAFE Banking Act. Proposed as an amendment to the Dodd bill, this act would break up too-big-to-fail Wall Street megabanks and install firm, unambiguous limits on the nation's financial behemoths.

The bill has three key components. First, banks would be barred from holding more than 10% of the nation's deposits -- end of story. Current rules already assert such restrictions, but they're obnoxiously easy to circumvent. Bank of America (NYSE: BAC) and JPMorgan Chase (NYSE: JPM) have blown right past 10% in recent years without breaking a sweat.

Second, there'd be limits on how much financial institutions could borrow from non-deposit sources of funding, such as short-term debt. For banks, the limit would be 2% of GDP, or about $290 billion in today's economy. For non-bank financial firms such as AIG (NYSE: AIG) and General Electric (NYSE: GE), the cap would be 3% of GDP, or about $440 billion.

Third, leverage at all banks would be capped at 16-to-1, meaning a mandatory 6% capital ratio, period. No more of the 30-to-1, or even 50-to-1, leveraged suicide missions that got banks into this mess to begin with.

These rules would cause the largest banks and pseudo-banks to shrink in dramatic ways, either by selling assets or breaking themselves up like Standard Oil did a century ago. To get a sense of the scope of any potential changes, Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) now hold $778 billion and $724 billion in total liabilities, respectively. Under the SAFE Banking Act, both would effectively be forced to shrink by more than 60%.

This is anything but extreme, since the new Baby Banks would still be some of the world's largest financial institutions. But critically, when combined with a sensible liquidation process and derivatives reform, the SAFE act would bring today's banks down to a size that would allow them to fail. Under the new rules, banks would be held accountable for their own mistakes. Those that fail would go out of business in a calm, coherent way, without spewing collateral damage throughout the economy. In other words, we'd see the return of capitalism.

We're cheering loudly for it, and we think you should, too. The SAFE Banking Act to shrink Wall Street megabanks is gaining momentum, and it has a real chance of making it into the final financial reform bill. We count 20 senators who have already taken a strong stand in favor of breaking up too-big-to-fail banks. The best way we can make a difference is for all of us to contact our senators now, and tell them that we need them to support the SAFE Banking Act to put hard caps on bank size and end the need for taxpayer bailouts

Let's do this, Fools!
We've called our respective senators today to ask them to support the SAFE Act. It took only five minutes, but we made sure that our representatives heard us at this critical time for financial reform.

Click here for your senator's phone number. There is also a major petition going around in support of the SAFE Banking Act, which you can sign here.