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June 18, 2009

Break-up Big Banks to Increase Shareholder Value and Reduce Systemic Risk

Since before the Federal Government decided to get in the game of bailing-out the banks last fall, I've been of the opinion that it would be better for the Federal Government to not let banks get too big to fail and to break them up into smaller pieces when they get too big, so they don't become a systemic risk, instead of bailing them out.  After Microsoft was being threatened with being broken-up, I saw the fallacy in trying to break-it-up into two or three monopolies instead of 5-10 competing companies, like when Standard Oil was broken-up.  While pondering this possibility for banks, I realized that breaking-up big banks into smaller banks might also have additional huge benefits to both the bank shareholders, the financial system, and taxpayers.

Rules of the System
Here are some general rules that would guide the benefits of this system:

  1. Banks too big to fail, maybe $500billion+ in assets, will be broken into  banks with $100-200 billion in assets
  2. The "Child" banks are not allowed to merge with nor acquire other child banks for 5-10 years (unless they are being liquidated), but they may merge with and acquire non-child banks (non-child banks do not include the children of other big banks that were broken-up, those are still child banks).
  3. All child banks of a given parent bank, will each get the same systems, procedures, and technologies that their parent had, just like if the parent was a bacteria and duplicated itself into a bunch of children.  This way they all face a level playing field, with their siblings.
  4. The shareholders in the parent bank, get equal shares in each of the child banks.

Benefits to Bank Shareholders
First to the bank shareholders, because any move should make sure the shareholders can see their return increased.  Big banks like any big company will come against the law of large numbers and have their growth stall once they become huge, since as they grow larger, the amount of revenue growth they need in order to increase their returns grows along with their new revenue levels.  Small banks don't face this limitation.  Therefore, the children of the best run big banks will be able to grow faster than their parent by acquiring, absorbing, and instituting their best practices into other banks.  Giving shareholders a stake in each will allow the shareholders to see their returns potentially increase at a much faster clip, while at the same time spreading their risk.  For example, JP Morgan and Wells Fargo shareholders could see huge gains in shareholder value by having this system adopted, because both banks are incredibly well-run. (Full disclosure, I've had family members work at Wells Fargo and I own stock in it through a family, stock partnership.  Also I have a good friend at JP Morgan. :)

Benefits to the Financial System
Second to the financial system, because we don't want the system to come crashing down around us.  The big banks that are not run well, when broken into smaller pieces, will have their bad pieces go under, because the smaller, bad banks won't be able to spread their risk over a larger bank and hide their troubles.  This will provide more room for the well-run banks to grow.  What then happens is the bad practices are destroyed faster and the good practices are able to grow faster, which leads to greater productivity growth and a more stable system overall, especially since the bad banks are reduced to banks that won't damage the overall system after they eventually fail.

Benefits to Taxpayers
Finally to the taxpayers, since the banks that are too big to fail will be broken-up, there will no longer be a need for bailouts, ever, which will save us hundreds of billions if not trillions of dollars in the future.  No more Citi's, Bank of America's, and AIG's will be sinkholes for our money. 

Turning-up the dial on creative destruction can be a great thing.

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