Making America Safe Doesn't Mean Death to Bank Investors

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Mention the idea of breaking up the U.S.'s big banks and you'll likely hear that if we don't, the country's economy will eventually be blown to bits by banker excesses. Of course, you're also bound to hear someone say that if we do break up the banks, the economy is bound to shrink into oblivion as liquidity and capital flows go up in smoke.

The interests of the two sides may not actually be that far apart.

In a speech to the U.S. House of Representatives yesterday, Thomas Hoenig -- current director at the FDIC and former head of the Kansas City Federal Reserve Bank -- makes a compelling case for breaking up the biggest banks. He also hints at why it might not be all that bad for bank investors.

Hoenig starts by pointing out that the largest U.S. bank by assets -- JPMorgan Chase  (NYSE: JPM  ) , if you were curious -- has $2.4 trillion in assets, which equates to 15% of U.S. GDP. The largest eight U.S. banks have $10 trillion in assets, which is roughly 66% of GDP. 

And even though U.S. banks carry less leverage than their global counterparts, when judged on international reporting standards and eliminating non-tangible equity, big U.S. banks have surprisingly high leverage. Bank of America  (NYSE: BAC  ) , for instance, has a leverage ratio (that is, tangible equity divided by calculated assets) of just 3.55%. JPMorgan's is 3.48%, while Citigroup's (NYSE: C  ) is 3.57%.

As we saw during the financial crisis, bigger banks can be a big danger to the economy. But Hoenig doesn't think the solution is simply making big banks smaller. He's fixed on making sure that true banks are only operating in true-blue banking businesses and, therefore, only getting a "government safety net" (as he put it) for those businesses. He explains:

Commercial banking organizations that are afforded access to the safety net should be limited to conducting the following activities: commercial banking, securities underwriting and advisory services, and asset and wealth management. Most of these latter services are primarily fee-based and do not disproportionately place a firm's capital at risk.

That means that, specifically, broker activities like market making and most derivatives work would need to be jettisoned. While the knee-jerk rebut might be to suggest that this would somehow hurt the economy, Hoenig notes he's "not aware of research that suggests ... that economic growth would suffer with commercial banking separated from broker-dealer activities." He continues:

It is a fact that the emergence and continued success of the U.S. economy from the end of World War II to the 1990s happened during a period where commercial banking was separate from investment banking. Here's one data point: the growth rate of real GDP averaged 3.3 percent from 1955 to 1990, but only 2.3 percent from 1990 to the present.

That may not be a result of just the differences in the banking system, but it does suggest that the economy can grow quite well without big banks taking on big trading risk.

Interestingly, a group that might be most opposed to this idea -- investors in the big banks -- could actually be in a position to benefit if this idea came to pass. If the big banks had to spin off their broker-deal divisions, the newly solo businesses might face higher funding costs without the backing of a giant commercial bank. But they could still be highly successful as stand-alone units.

You can call Goldman Sachs  (NYSE: GS  ) a lot of things, but from a financial-results perspective, it's a broker-dealer. In 2012, nearly 80% of the company's pre-tax profits came from the Institutional Client Services and Investing and Lending divisions, which in large part conduct the kinds of activities that Hoenig doesn't want commercial banks participating in.

In other words, assuming you start with a good overall bank, if you split off the targeted activities, you could be left with a quality commercial bank and a quality broker-dealer investment bank. With the entities separate, more clarity could even lead to higher market valuations -- which would obviously be a plus from a shareholder perspective.

Perhaps it would also be a long-term benefit to the operations of the split businesses. If Bank of America has done nothing in the past few years, it's proven that managing a financial superstore of that size is a challenging task -- if it's even doable. Hoenig contends that more focused banks may, over the long term, be better banks:

[Adam Smith] argued well that specialization most often increases productivity. I suggest that in the financial services industry, specialization would do much to increase productivity, innovation and other overall benefits to our economic system.

I remain highly skeptical the political will exists to break up the big banks in any way. That said, as a big-bank shareholder myself, that's one "threat" that doesn't keep me up at night.

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