Banks too big to fail: Should they be propped up, or split up?

too-big-to-fail-banks-should-they-be-propped-up-or-split-upHow can the U.S. solve its systemic banking issues? If you're former Federal Reserve Chairman Paul Volcker (pictured) or Bank of England Governor Mervyn King, your answer would be: Let's split up the banks. Volcker would like to see some form of a Glass-Steagall-like bill passed to reconstruct the wall between commercial banking and investment banking. Glass-Steagall, a law passed after the Great Depression, was repealed in 1999.

But from actions they've taken, it appears that others, including current Fed Chairman Ben Bernanke and current Treasury Secretary Timothy Geithner, think propping up the largest banks is the best way to go. In fact, they clearly like to see big banks getting bigger. John Mack, CEO of Morgan Stanley (MS), has spoken of the pressure he faced from Bernanke and Geithner to merge Morgan Stanley with JPMorgan Chase (JPM) during the depths of last year's crisis. Bank of America's (BAC) tale of woe regarding how it was pressured to acquire Merrill Lynch is very similar in tone.
Former Fed Chairman Alan Greenspan comes down somewhere in between the Volcker and Bernanke/Geithner camps. He thinks banking regulators should consider breaking up financial institutions considered "too big to fail," but doesn't support reinstating Glass-Steagall. He believes that by marrying investment banks with commercial banks and allowing them to become too big to fail, the U.S. has created an illusion that allows them to borrow at lower cost, because lenders believe the government will always back them up, Greenspan told the Council on Foreign Relations. He went on to say that the current situation squeezes out competition and creates a danger to the financial system, according to a report in The New York Times.

Volcker definitely wants to turn back the clock to an era when commercial banks were prohibited from engaging in risky Wall Street activities. He believes the banks exist to serve the public and that is what their mission should be. He thinks investment banking activities create conflicts of interest and promote risk taking. Volcker wants President Obama to shield commercial banking from Wall Street's excessive risk taking. In his view, commercial banks should only be allowed to take deposits, manage the nation's payments system, make standard loans and trade securities for their customers, but not for themselves.

The others on Obama's economic team want to let the giant banking entities survive essentially as they are now, but want to regulate them extensively in order to prevent them from getting the country into trouble again. But how's that working out so far? Legislation is stalled in the Congress, banks are once again engaging in their most risky activities, and they're planning to pay out billions in bonuses for 2009.

Robert Pozen, chairman of MFS Investment Management, agrees with Bernanke and Geithner that a new version of the Glass-Steagall Act should not be instated, but I doubt he would agree with extensive regulation. He thinks the repeal of Glass-Steagall "helped to reduce the severity of the financial crisis. When Bear Stearns and Merrill Lynch got into serious trouble, they were promptly acquired with Federal assistance by JPMorgan Chase and Bank of America, respectively," Pozen writes in a Forbes commentary.

But that's exactly the response that Greenspan believes gives lenders and investors the incorrect impression that the government will always step in and protect giant banks. We can't allow that impression to continue to fester. At the very least, we must either create smaller entities as Greenspan suggests, or rebuild the wall between commercial banking and investment banking as Volcker wants.

Some think that those interventions would not work, given the globalization of financial markets. But policymakers must decide: Do we want a commercial banking industry that serves the needs of the American public, or do we want an industry that takes massive global risks and expects the U.S. government bail it out whenever something goes wrong?

Lita Epstein has written more than 25 books, including Trading for Dummies and The Complete Idiot's Guide to the Federal Reserve.
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