Maybe it’s time to break up the banks

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As the Senate takes up debate on financial industry overhaul, there is one issue above all others that is imperative to work out: how to deal with institutions that are Too Big To Fail. The reason the government stepped in with taxpayer money at firms like Citigroup and AIG is still alive and well. Our financial giants are so behemoth and interconnected that should one quickly go out of business, the entire system could be at risk.

Unfortunately, as an increasing number of commentators are pointing out, the solution Congress is currently contemplating will likely do little to change that.

The legislation that came out the Senate banking committee which is currently up for debate does take a lot of steps. It sets up a new regulatory board to determine which institutions are a “systemic threat.” Those companies would fall under fresh scrutiny, and if the Federal Reserve, along with the new board, determined that there was a problem, they could require the company to sell off parts of its business—or wind down altogether. To pay for this, institutions would be taxed to create a $50 billion fund.

This solution has a number of problems. The core one is that it doesn’t actually address the fact that companies are too large and interconnected. It merely sketches out a process for dealing with any potential fall-out. A second big problem is that the bill trusts regulators to be able to identify and pre-empt systemic threats. Regulators didn’t do such a hot job of that in the lead-up to the 2008 crisis.

Now that the bill is being debating in the Senate, other ideas are being put on the table, most visibly from Senator Richard Shelby, the ranking Republican on the Democrat-controlled banking committee that signed off on the original bill. Shelby wants to do away with the $50 billion fund and gain assurances that companies’ shareholders and bondholders take a real hit when their company collapses. This is a noble effort to remove a government-mediated safety net and let financial players know that if they take big risks and fail, they will be the ones to suffer. Other good ideas, like forcing banks to issue debt that would be converted to equity in the event of a crisis, have a similar goal.

Increasingly, though, I’m coming around on the idea that even these efforts don’t go far enough. These ideas are all still about how to deal with the aftermath of a massive financial institution bringing the system to the brink, not preventing that from happening in the first place.

Is there anything that would keep too much power and importance from building up inside of any single financial institution? It’s tough to say for sure, but what is starting to be clear to me is that only one course of action has a real shot: breaking up the big banks.

A scary thought, I know. Not just from a political standpoint, but also because Americans are generally in favor of big things (big cars, big-box stores, Big Gulps) and against penalizing businesses for being successful and growing.

On the other hand, we’ve got American history on our side. Breaking up big financial institutions is exactly what Congress did in response to the forces that caused the Great Depression, realizing that size inherently is dangerous—that financial firms are ultimately run by human beings, and human beings only have so much capacity to prudently manage complexity, risk and largess.

There are some very smart, well-informed people in favor of a new big bank break-up. Richard Fisher, the president of the Dallas Federal Reserve, is one. Another is Delaware Senator Ted Kaufman, who has an MBA from the University of Pennsylvania. Last week he, along with Senators Sherrod Brown, Robert Casey, Sheldon Whitehouse and Tom Harkin, introduced a bill that would impose hard caps on how large banks can get in terms of liabilities, leverage and market share of insured deposits.

In his floor speech to introduce the bill, Kaufman argued that Congress needs to codify specific limits now, while the effects of financial crisis of still being felt, because eventually business-as-normal will resume. The economy will rebound and finance firms will be emboldened and regulators will get swept up in the mindset too. In good times, everyone forgets why it’s sometimes necessary to hold such a hard line.

And if anyone should get that, it’s Senator Shelby. Those Depression-era limits on the banking industry lasted for generations—until Congress repealed them in 1999 after a massive lobbying effort from the financial industry. Only eight Senators voted against repeal. One of them was Shelby.