In recent months, the case has been made again and again for the breaking up of major banks. While much of the argument has centered on whether Glass-Steagall would have prevented the financial crisis, another, more present argument is that shareholders are being kept from the returns that these banks could be earning if their value-generating divisions were allowed to step out from under the shadow of investment banking. Is management cheating big-bank investors?

The case
In a rare moment of usefulness, CNBC interviewed former Morgan Stanley chief Phil Purcell, where he made what I think is the strongest case yet for the break-up of the major banks -- Bank of America (NYSE: BAC) and Citigroup (NYSE: C).

Purcell isn’t advocating the reinstatement of Glass-Steagall -- he just wants the big banks’ higher value businesses to see the light of day in the form of spin-offs. Specifically, Purcell thinks a tax-free spin-off of a business such as credit cards would give tremendous value to existing shareholders, who would receive shares of the new company.

The man speaks from experience. During his tenure at Morgan Stanley, Purcell spearheaded the spin-off of the company’s Discover (NYSE: DFS) credit card service. The stock has outperformed tremendously, and trades at a book value of $2.22. Compare that to Bank of America’s $0.45. The reason investors can buy Bank of America for less than $.50 on the dollar is because the company is muddied in its investment banking practices, as well as its commercial loan business. Discover trades at such a high book value because it is a clear and simple business model that is highly profitable and very shareholder-friendly.

And when you look at a bank that doesn’t have the intensive investment banking and complicated business models, it trades closer to Discover than Citi. Wells Fargo (NYSE: WFC), for example, trades at 1.32 times book value. Granted, Wells Fargo is also a market darling, and buoyed by Warren Buffett’s constant praise, but it is no mistake that this bank trades at a richer, more confident valuation than its mega-bank counterparts.

What should happen
Take a look at Citigroup. Citi trades at around 7.5 times forward earnings, and for about .5 times book value. This is similar to Bank of America’s situation -- paying $0.50 on the dollar for the face value of the firm’s assets. The reason is also the same -- a murky situation that the market has a hard time putting a number on.

Citi has a credit card division that is, according to Purcell, about three times bigger than Discover. As a whole, Citigroup is worth a little under $100 billion. If it were to spin-off its credit card division, and that new company were to trade at a similar price-to-book valuation, the credit card business alone would be worth roughly $60 billion. Is Citi’s credit card business 60% of the company on paper? Absolutely not. But if it were its own entity, Purcell argues, it would be worth at least that much.

I'm a big fan of the spin-off method. The tax savings and value discovery has helped countless companies and their shareholders.

By keeping these TBTF banks together, management is not only perpetuating a dangerous theory, it’s keeping its shareholders from earning the returns they should be getting. When you want something done on Wall Street, you should piss off the shareholders. Someone should call Bill Ackman and tell him to get on these guys’ cases.

Irregulation
On a different, but equally important note, Purcell also talked about how big bank accounting rules have accomplished the opposite of what should be happening. Purcell said:

Instead of over-reserving in the good times and under-reserving in the bad to cushion the blows, they changed the accounting rules so you do just the opposite. In the good times you reserve nothing. In the bad times you have to over-reserve. That's why the banks in the last couple years have been emptying reserves.

His simple explanation makes perfect sense. Banks should save when they are flush with cash, not vice versa.

The one thing I challenge in his argument is that businesses don’t want to borrow, and banks can’t force them to. For large corporations, this may be true. After the massive deleveraging following the financial crisis, many large companies are scared to saddle up with debt, as they should be. But my attention is more focused on small and mid-sized businesses, which I believe still have a tough time finding the financing they need.

If the banks started lending more to small companies, they would be fostering innovation, fostering jobs and, ultimately, furthering the economy.

If you liked this…
The major banks require considerable analysis before making any investment decision. For a quick start courtesy of our analysts here at the Fool, check out this premium report about Bank of America that outlines the company’s opportunities and hurdles.