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Why the Big Banks Have to Break Up

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Greater government involvement is now necessary.

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I am a Capitalist Pig, and proud of it, thus you wouldn't expect me to support government interference and more strenuous regulation of financial institutions -- after all, capitalism (free markets) and tight regulation don't mix well. Well, at the risk of been kicked out of the Capitalistic Pig Party, I'm in support of tighter regulation of too-big-to-fail (TBTF) institutions -- the likes of Citigroup (C), JPMorgan (JPM), Bank America (BAC), and (God forbid; after all, it is doing "God's work") Goldman Sachs (GS).

Lack of tight regulation in the TBTF space leads to the worst economic system of all: asymmetric socialism. The enormous gains are reaped by employees and shareholders, but losses are socialized and paid by taxpayers. That's simply immoral.

Letting companies fail is at the core of capitalism's DNA, and I still stand by that. However, what we've discovered over the last few years is that if we let TBTF banks go bankrupt, their failure may take down other healthy (interlinked) financial institutions and derail the real (nonfinancial) economy.

We saw glimpses of that about to happen when Lehman went bankrupt. If the government hadn't stepped in to guarantee money-market funds (and almost everything else on Earth), the real economy would have stopped in a few days, with massive withdrawals of funds from money markets and a shutdown of the commercial paper market, which in turn would cut off healthy companies like IBM (IBM) from regular day-to-day activities, such as financing their inventories and paying their employees.

Our financial system operates on the assumption of continuity: We assume tomorrow will arrive and that we'll be able to get our money out of the banks if we want to. A failure of large financial institutions is akin to an earthquake of magnitude 9 on the Richter scale taking place in New York, but with aftershocks of 7 magnitude ripping throughout the country; and at the end of the day (or the week) the whole country ends up in ruin.

I could be wrong, and the failure of a large bank might end up being not such a significant event, but we will never find out, as the cost of being wrong is too high. So we end up with the imperfect world we live in -- the big banks won't be allowed to fail.

This imperfect world leads us to two realistic solutions:

1.
Create incredibly strenuous regulations that will require significantly higher equity-to-debt ratios than for smaller banks and severely restrict the activities of TBTF institutions. Basically, they need to be turned into regulated utilities, like your local gas and water companies. Permit their "God's work" to be limited to only very transparent traditional banking activities -- so they can't fail. Separate the leveraged hedge fund (the proprietary trading operation) and the bank (the institution that takes deposits and makes loans). In other words, bring back a more sophisticated version of Glass Steagall.

2.
Break them up by either making their lives unbearable through the strenuous regulation described in option 1 or simply by legislating it, as was done with AT&T (T) in the 1980s.
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No positions in stocks mentioned.

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