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The Fed Insider Who Wants to Break Up the Top Banks

By Alex Dumortier, CFA - Feb 17, 2016 at 1:44PM

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Minneapolis Fed bank president Neel Kashkari, formerly of Goldman Sachs, thinks regulators should consider breaking up the largest banks.

U.S. stocks are enjoyed a nice rally on Wednesday morning, which lifted the S&P 500 (^GSPC -0.16%) out of correction territory. The Dow Jones Industrial Average (^DJI 0.23%) and the S&P 500 are up 1.41% and 1.51%, respectively, at 1:42 p.m. ET. Traders appear to be taking their cue from the oil market: A day after Saudi Arabia and Russia announced they would freeze oil production levels, new market entrant Iran says it supports efforts to stabilize prices.

Neel Kashkari. Image source: Wikipedia.

Oddly, the banking sector is underperforming the broad market today (this Fool would have expected the opposite). And speaking of Minneapolis Fed bank president Neel Kashkari did not pull any punches in his first public speech, saying the top U.S. banks represent a "nuclear" threat that "continue to pose a significant, ongoing risk to our economy." He went on to say that a breakup of these "too big to fail" institutions ought to be on the table, in addition to further capital surcharges.

An insider's view
The topic of banking regulation has gained prominence as a result of the Democratic presidential campaign. Senator Bernie Sanders, the self-described "democratic socialist" who is seeking the nomination, supports a break-up of the largest banks -- he introduced a bill to that effect last May.

The tone and the content of Kashkari's speech come as a bit of a surprise, as he has impeccable credentials as a financial system insider: Following four years in Goldman Sachs, he joined the Treasury department, initially as a senior advisor to Treasury Secretary (and former Goldman CEO) Hank Paulson.

As an assistant Secretary, he administered the $700 billion Troubled Asset Relief Program (TARP), which took stakes in the top banks in order to stabilize the financial system. He then spent four years as a managing director and member of the executive office at PIMCO, the world's largest bond fund manager.

Have banks gotten bigger or larger?
Steven Rattner, the financier and former auto czar, represents the more conventional insiders' view. Speaking on Bloomberg Television yesterday, Rattner said:

The big banks, in fact, are not as big as people think they are... The biggest banks have actually gotten smaller since the financial crisis, not larger. Everybody says that [they got bigger] and they did get bigger for a second when they took over some failing institutions, when Wells [Fargo] took over Wachovia, when JPMorgan took over Bear Stearns and so on, but if you start from after that round of rescue acquisitions was done, the banks with over $500 billion of assets – i.e. the biggest banks – have actually shrunk a little bit. Banks smaller than $500 billion have all grown significantly.

That's a red herring: Why on earth would you start counting after a round of major acquisitions that were the result of the financial crisis and which contributed to a consolidation of the industry?

Here are the hard numbers: At the end of 2007, U.S. commercial banks with greater than $100 billion in assets accounted had total assets of $6.4 trillion, or 57% of all commercial banks' assets. By the end of last June, that percentage had risen to 64%.

(I looked at banks with total assets of $100 billion, because regulators including the Federal Reserve use that figure as a cutoff to designate too-big-to-fail institutions -- or "systemically important" institutions, in bankers' lingo.)

No extremist proposal
This Fool does not consider the proposal to break up the banks extreme, much less the call for greater capital cushions, and Kashkari is not alone among the policymaking/regulatory elite. In 2012 speech to the annual central bankers' retreat in Jackson Hole, Andy Haldane, the highly respected head of Financial Stability at the Bank of England, called for capital requirements well beyond those mandated under the new Basel III framework.

For bank shareholders, there is a trade-off between safety and profitability, as lower leverage ratios mean lower returns on equity. Under the assumption that that current capital requirements hold, however, several of the top banks continue to offer good long-term value for investors.

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short March 2016 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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