It's Time to End 'Too Big to Fail'

Of the 8,195 banks in this nation, just four, JPMorgan Chase (NYSE: JPM), Citigroup (NYSE: C), Wells Fargo (NYSE: WFC), and Bank of America (NYSE: BAC) control nearly 40% of the deposits. Those four, plus Goldman Sachs (NYSE: GS), hold 97% of the industry's notional derivative exposure.

These statistics would be hilarious if they weren't true, and if the banks behind them didn't have the power to manipulate vast portions of the economy. We spent the latter half of 2008 feeling the wrath of "too big to fail." Today, banks are bigger than ever. We need to end that. Now.

Here's why
We all know the downside of "too big to fail." They screw up; we pay the price. Yet many people (mostly bankers) still defend the practice. So rather than firing off reasons why "too big to fail" is such a menace -- you already know those -- we'll refute the arguments defending it.

Start with the first argument -- that post-Lehman, the problem has evaporated. JPMorgan Chase CEO Jamie Dimon, for example, recently argued that his bank wasn't too big to fail. Wrong. JPMorgan Chase is not very likely to fail at the moment, but let's not pretend that the eruption of its balance sheet, with more than $79 trillion in notional derivative exposure (we're not making that number up) wouldn't annihilate everything in sight.

Plus, we'll remind you that AIG, Bear Stearns, Lehman Brothers, Citigroup, Washington Mutual, Fannie Mae, and Freddie Mac all once gave off the impression of being "not very likely to fail," too. Overcoming the notion that last fall's financial crisis was a random, one-off event is perhaps the most crucial aspect of stabilizing the financial industry. Last fall was no fluke. It will happen again.  

Moving on to the grittier arguments, Dimon has also been quoted as saying: "Large businesses are large for a reason. You can't do an $8 billion loan if you are a small bank."

No, but can't eight smaller banks lend $1 billion each? And that way, wouldn't competition flourish, since those smaller banks would all bid against each other on loan terms? Increasing the number of competitive banks doesn't reduce the total amount of capital in the financial system. 

There were huge, prosperous, industrial companies far before there were banks with multitrillion-dollar balance sheets. We think it's plainly clear that the overall economy fared far better when three or four banks didn't hold the economy in a headlock. In fact, this seems utterly obvious to everyone except the big banks.

Like Dimon, other advocates of too-big-to-fail banks like to cite vague, specious evidence. Here are the reasons we hear most often:

"Big banks are more efficient"
This would be a good point -- if it were true. But the evidence suggests otherwise. From a Federal Reserve survey of thirty-nine studies on merger performance from 1980 to 1993: "The findings point strongly to a lack of improvement in efficiency or profitability as a result of bank mergers, and these findings are robust both within and across studies and over time." Ouch.

More recent studies -- even the one selectively quoted by a prominent too-big-to-fail advocate -- reveal similar findings: "Efficiency does not significantly increase with bank size as one might expect if economies of scale are an important determinant of success."

If size were a significant advantage, you would expect large banks to be doing really well. But over the past two years we've seen just the opposite, as every single major convoluted bank not only failed, but failed so spectacularly that they had to be bailed out by the government. Most smaller, regional banks that didn't run massive blind, drunk trading desks fared far better.

"Our broken-up banks will have a competitive disadvantage to sprawling foreign banks"
This point assumes that there are advantages to scale, which, as we've seen, is probably false. Moreover, it's become irrelevant since Europe, which recognizes the risks big banks pose, has the courage to break up theirs -- the list so far includes Lloyds, Royal Bank of Scotland, Northern Rock, and ING.

"Large, sprawling multinationals need large, sprawling banks"
It's curious that the financial-services industry would be the only one whose customers want their suppliers to be powerful and consolidated. In reality, there's a reason why large companies don't do all of their business with a single bank -- you have more risk and less bargaining power when you rely on fewer suppliers. Peter Boone and Simon Johnson note that General Electric's (NYSE: GE) 2008 stock offering used seven lead managers, while Microsoft's (Nasdaq: MSFT) May bond offering used seven lead and joint lead managers. Smaller companies also like to spread their business around.

That's why you don't see any companies, other than the major banks, up in arms about the possibility of banks being broken up. They would benefit from greater competition and financial stability.

Remember, advocates of the current system have to show that the size and complexity of too-big-to-fail banks provide benefits that are worth more than seven million jobs and trillions of taxpayer dollars, plus whatever economic devastation future crises cause. But they still have not given us any good reason to keep these giant Bankensteins around, much less one that justifies these tremendous costs.

So if efficiency isn't the question, why would the CEOs of banks be so gung-ho about becoming large and in charge? Sometimes a pair of simple tables tells a powerful story:

JPMorgan Chase ($2 trillion in total assets)

Source: Capital IQ, a division of Standard & Poor's.

Bank of the Ozarks ($2.9 billion in total assets)

Source: Capital IQ, a division of Standard & Poor's.

If you're a CEO, you don't build dynastic wealth for yourself by being small and nimble. You do it by being an enormous, sledgehammer-wielding giant.

Those who don't have a vested interest in the matter often agree. Paul Volcker, Alan Greenspan, and Mervyn King, Governor of the Bank of England, have all argued we need to break up the banks and/or stop them from running proprietary trading desks.

Heck, even John Reed, the former chairman of Citigroup who got the bank-regulating Glass-Steagall act repealed, wants it back: 

I'm sorry …. We learn from our mistakes …. I would compartmentalize the industry for the same reason you compartmentalize ships. If you have a leak, the leak doesn't spread and sink the whole vessel.

Help us out here
We simply want to see one, logical, clear explanation for why we shouldn't break the banks apart -- or bring back Glass-Steagall, separating investment banking and trading activities from commercial banking. Just one.

So far, the popular explanation is, "Well, it wouldn't solve all of our problems." Neither does outlawing theft, but that doesn't mean we should pooh-pooh its importance. In our opinion, no one has rationally shown why the economy is better off when three or four banks dominate the land, as opposed to breaking them apart, ending "too big to fail," and letting competition run free. In fact, the evidence seems to thoroughly disprove it.

We're fairly certain there's one real reason why we haven't found the courage to take these necessary steps. Everyone in Washington must know that any such effort will invite a flotilla of banking lobbyists to come sailing in, cannons blazing, threatening to undermine campaigns and derail re-elections. Heck, we'd be scared of them, too. We just want someone to name that fear as the reason why a handful of banks continue to hold the economy hostage. And if that isn't the reason, please tell us what is. We're dying to hear.

To help Congress along, we'll make sure each and every one of its 535 members gets a copy of this article in their email inbox, so they'll have a chance to speak up and defend our current financial system. We've also sent this article to the major banks and their trade associations. Members can respond to either of the email addresses we've provided below.

We're waiting.

In the meantime, we can all call our Senators and tell them to support the SAFE Banking Act, which would put a hard cap size on too-big-to-fail Wall Street banks.

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.

Ilan Moscovitz and Morgan Housel have no financial interest in any company mentioned in this article. Microsoft is an Inside Value recommendation. Motley Fool Options recommended a diagonal call on Microsoft. The Motley Fool is investors writing for investors.