Battle Over Mega-Banks Enters New Phase

(MoneyWatch)  A new front is opening on the war over financial reform. The fight has shifted in recent months from how to regulate "systemically risky" companies to whether they should exist at all.

Dug in on one side are lawmakers, financial industry critics and others who favor making big banks smaller and forcing them to exit risky businesses, such as trading securities. Here's Rep. Paul Kanjorski, a Pennsylvania Democrat, in the WSJ today on his plans to introduce legislation that would limit the size of financial companies (subscription required):

"I see it as one of our potentially last chances to get control, particularly of financial institutions in their mega-forms, before they take over the world. It's a natural drive of capitalism to escape control and escape regulation and to keep growing to any size."

Sen. Bernie Sanders, D.-Vt., took an even tougher stance last week in proposing a bill to "identify and break up" financial institutions deemed too big to fail.

"If an institution is too big to fail, it is too big to exist," he said in a statement. "We should break them up so they are no longer in a position to bring down the entire economy. We should end the concentration of ownership that has resulted in just four huge financial institutions holding half the mortgages in America, controlling two-thirds of the credit cards and amassing 40 percent of all deposits."

Under this view, it doesn't matter how strictly you regulate large financial institutions. Regardless how carefully they are watched, such companies are marvels of innovation, growing florid new financial products through the regulatory cracks. Best to chisel these companies down to size and confine them to their traditional activities of lending and taking deposits.

That's the emerging consensus in Europe. Not content merely to ratchet up regulatory scrutiny of mega-banks, policymakers have begun breaking them up, including the Netherlands' ING Groep and the U.K.'s Royal Bank of Scotland and Lloyds Banking Group. And in the U.S., such views, once mostly purveyed by liberal economists and pundits, have gone mainstream. Adherents range from former Federal Reserve chairman Paul Volcker to ex-Citigroup CEO John Reed.

On the opposite side, unsurprisingly, are financial institutions, along with critics of government "meddling" in the private sector. Globalization demands global companies, they argue. While these interests concede the need for tighter regulation (even as they continue to attack such efforts), they reject the idea that the size and complexity of financial players presents a problem. Most of all, they warn against tampering with, to use Kanjorski's phrase, the "natural drive of capitalism."

Interestingly, they've found an ally in the Obama Administration. The government has to date stopped short of questioning the necessity of mega-banks in favor of patching up the regulatory framework established in 1999 by the Gramm-Leach-Bliley Act. This approach favors, for instance, forcing banks to hold more capital and remain more liquid.

Despite the financial crisis, leading reform proponents in Congress and in the White House seem content to plug the boat, rather than build a new one. Rep. Barney Frank, D.-Mass., head of the powerful House Financial Services Committee, has said it would be hard to repeal Gramm-Leach-Bliley. And Connecticut Democrat Chris Dodd, chairman of the Senate Banking Committee, today unveiled a financial reform package that takes on a host of issues, including securitization, derivatives and credit ratings. But it preserves the contours of the current system.

Breaking up big banks is no panacea. Although it might do something -- a lot, even -- to lessen the danger they pose to the financial system, it may not solve the "too big to fail" problem, since even large lenders or insurance companies can run into trouble.

And yet letting leviathans roam, even on a shorter chain, seems even riskier. Gramm-Leach-Bliley didn't only usher in a period of massive banking industry consolidation, spawning the kind of giants we're wrestling with today. It fundamentally changed banking by merging traditional lending activities with the capital markets. It turned bankers into financial engineers. It gave rise to a "shadow banking" system that grew beyond our control or understanding. And it chained entire national economies to the fate of a few corporations.

That edifice still stands. Regulation may not be enough.