Is it time to break up the big banks?

FT.com

Facing the loose equivalent of today's banking behemoths, Theodore Roosevelt resolved to forge a "newer and more wholesome doctrine” to deal with "monopolistic combinations and conspiracies”. Woodrow Wilson proclaimed: "I am for big business, and I am against the trusts.” Today's leaders, who also govern in a time of technological progress and social inequality, must learn from Roosevelt and Wilson. Modern banks are worse than the rail and oil conglomerates of yesteryear. They must be broken up.

It would be irresponsible to espouse such radicalism if an alternative might work. But the debate since the collapse of Lehman Brothers has left little hope of a more moderate path. The best minds in academia and government have grappled with the challenge of 'too-big-to-fail'. They have advanced ideas that will help at the margin, but have fallen short of a solution.

The firestorm over Barclays and the Libor interest rate is only the latest evidence supporting this verdict. In Britain, the scandal has revived calls for a firewall between deposit-taking high street lenders, who ought to be cautious, and risk-hungry investment banks. But firewalls and other semi-separations tend to melt in a crisis. In 2007, institutions such as Citigroup and Bear Stearns held mortgage derivatives or hedge funds in supposedly segregated companies. But, to protect their reputations, they felt obliged to rescue those vehicles when they crashed.

Moreover, even if commercial and investment banking could be separated, finance will never consist of safe, government-insured lenders and risky but uninsured securities houses. Traditional lending is not safe, as the history of banking crises from Continental Illinois to Northern Rock make clear. Equally, the notion that investment banks should be left to take risks because they lack a government backstop is belied by US experience. When Bear Stearns collapsed, the Fed subsidised its transfer to JPMorgan Chase. When Goldman Sachs and Morgan Stanley faced the precipice, the Fed rescued them by allowing their instant reclassification as insured lenders.

The Barclays firestorm has also featured calls to change banking's 'culture'. When policy debates are dominated by the c-word, you know we are out of practical ideas. Social conservatives, despairing that government programs can reduce teen pregnancy or school dropout rates, throw up their hands and blame the culture of the inner city. In bemoaning the culture of the City of London, British politicians signal equivalent defeatism. People seem to forget that, in 2003, Citigroup ejected Sandy Weill, its hard-charging boss, and replaced him with Charles Prince, a cultural reformer. Prince's squadrons of enforcement lawyers did not prevent Citi hiding risks off its balance sheet.

The unconvincing reactions to the Barclays mess are echoed in the US. The Dodd-Frank reform featured the much-heralded Volcker rule, which aims to get banks out of proprietary trading. But when JPMorgan confessed that its London traders had lost billions, regulators weren't sure whether this was the result of legitimate hedging (permitted under the Volcker rule) or illegitimate trading. How can they enforce a ban on proprietary trading if they can't tell when it's taking place?

Most other financial reforms are similarly hard to implement. The single most powerful fix is for banks to hold more capital, but how to define the right amount? If regulators impose a simple leverage ratio, measuring a bank's capital against its assets, then they fail to distinguish between risky assets and safe ones, perversely rewarding banks that make the diciest loans. Alternatively, if regulators impose a risk-weighted capital ratio, they invite arguments about the details of the risk-weighting – and banks will exploit those arguments to hold less capital than they should.

Given the challenges in piecemeal regulation, it is necessary to consider a more radical approach. Rather than jury-rigging the existing system, or falling back on meaningless calls to change "culture,” political leaders need a modern version of Woodrow Wilson's dictum. Where Wilson was for business but against monopolies, today's leaders must be for finance but against banking behemoths. The instruments of finance, from risk models to derivatives, are useful when used responsibly. But the structure of modern finance – vast institutions that borrow cheaply because taxpayers are on the hook to save them – is an abomination that must stop.

In 2011 the hedge fund manager John Paulson lost more money than JPMorgan's London unit. Regulators didn't worry, because his private partnership is not too big to fail. We need a system in which more institutions resemble Mr Paulson's: simple enough to be manageable; focused enough to avoid conflicts of interest; and small enough to fail.

The writer, an FT contributing editor, is a senior fellow at the Council on Foreign Relations.