The Power to Break Up the Big Banks

The idea that behemoth banks should be broken up is widespread and bipartisan, embraced by regulators and politicians alike.

Regulators—past and present—including Simon Johnson, Richard Fisher and Thomas Hoenig have offered public support for downsizing and reforming “too big to fail banks.”

The latest to publicly embrace the idea is Sheila Bair, the Republican-appointed FDIC chair who was critical in dealing with the financial crisis.

Politicians also have become supportive of breaking up the big banks. Chief among them is Jon Huntsman, who made this issue the central focus of his presidential campaign, but even Newt Gingrich has expressed sympathy for splitting up financial institutions. The conservative media also has gotten into the act. The idea has garnered support from Bill Kristol of the Weekly Standard, Charles Gasparino of the Fox Business News Network and Arnold Kling of National Review, to name a few.

So, how do regulators actually do it?

They can use section 121 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 121 gives the Federal Reserve and the Financial Stability Oversight Council the authority to mitigate the “grave threat” that a financial institution poses by limiting the bank’s activities or forcing it to divest assets—in other words, the authority to break up a bank into separate institutions.

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If regulators do their jobs properly, the resulting institutions should be simpler, smaller, and safer. Those firms would be less likely to fail—and less dangerous in the event that they do.

Take Bank of America, for example. In its current form, it is a “grave threat” by any reasonable definition of that phrase. On Wednesday, Public Citizen filed a petition with financial regulators, calling on them to break up the bank and reform it.

The petition details how Bank of America is a systemically dangerous behemoth, holding $2.1 trillion of assets. That equals roughly 1/7 of U.S. gross domestic product and makes it the second-largest bank holding company in the U.S. Its size and number of different lines of business make it too complex to manage or regulate properly.

In addition, Bank of America’s financial condition is poor and could deteriorate rapidly. Near- and long- term financial indicators demonstrate the market’s unease with the firm. It likely is undercapitalized, as it faces potential liability and market risks that could severely destabilize it.

In fact, an ongoing study by the Volatility Institute at New York University’s Stern School of Business confirms the danger posed by the bank. Of all U.S. financial institutions, Bank of America contributes the most to systemic risk. This means not only that Bank of America is highly susceptible to financial crises, but also that it could “create or extend” a crisis.

If Bank of America in its current form were to fail, it would devastate the financial system. Regulators would have few options for dealing with an imminent failure, and all of them would be bad. These include bailing out the firm—something prohibited by the Dodd-Frank Act—or trying to put the bank through an orderly liquidation. There are many risks involved in putting such an unwieldy institution through liquidation. Many people think it wouldn’t work. In any event, it’s likely that a liquidation would be anything but “orderly.”

Luckily, these problems can be avoided. The Dodd-Frank law gives financial regulators the authority to act preemptively, safeguarding financial stability by engineering a soft landing for Bank of America well before a crisis materializes. It’s imperative that they use that authority.

We’re not saying that Bank of America is bound for a crisis. We’re saying that the possibility of a crisis is all too real—and it’s a risk we can’t afford to take. That’s why financial regulators must act now.