(By John Tamny)

It must be stressed that banks are large because economies of scale (geographical diversification is said to be another positive factor) make it smart to grow. If by government decree banks are broken up, it’s only a matter of time before they – through acquisitions – start swallowing each other once again in order to achieve the economies of scale, profitability, and other forms of return craved by investors.

A popular refrain on the left AND right ever since the financial crisis* is that to ensure nothing like it happens again, the banks must be broken up. Explicit here is that if no bank is too large, no one entity can ‘threaten the financial system’ if calamity strikes. They also presume that smaller banks mean no more bailouts. Both are nice thoughts, yet totally divorced from reality.

For one, U.S. banks aren’t all that large. In terms of assets, there are only two among the world’s ten biggest (JP Morgan Chase and Bank of America), and they rank 9th and 10th. The rest of the largest banks are foreign owned, so if you believe the ‘Mother of All Great Depression,’ ‘Crush the Financial System’ narrative as Ben Bernanke and the break-up-the-banks crowd do, sorry, but ‘systemic risk’ has a foreign address.

Never explained – at least very well – is why big is bad. In most other industries (particularly lightly regulated ones) a company grows large mainly because it’s serving the needs of the marketplace well. Banking, on the other hand, is a highly regulated industry, so it’s fair to assume that size at least to some degree is a function of political pull. Of course that’s one of many reasons why banks shouldn’t be broken up, as will be explained further along.

But first, lost on the break-up-the-banks crowd are notions of return-on-equity, profit margins, earnings, and other things that investors care deeply about. No investors, and no companies. Simple as that.

Applied to banks, if you break them up you’re almost by definition reducing their profit margins. Boost their capital requirements? To do so is to similarly reduce their ability to reward investors with high returns, at which point investment will flow to unregulated (this is a good thing) financial institutions, not to mention larger foreign banks not so encumbered.

It must be stressed that banks are large because economies of scale (geographical diversification is said to be another positive factor) make it smart to grow. If by government decree banks are broken up, it’s only a matter of time before they – through acquisitions – start swallowing each other once again in order to achieve the economies of scale, profitability, and other forms of return craved by investors.

To the above some will surely say that regulations will ‘ensure’ that banks will never grow large again. Doubtful, but even if it’s true, implicit in such a suggestion is that by regulatory decree banking will be an unprofitable, talent-free sector. Sorry, but if you limit the ability of businesses to grow, along with their profitability, you’re by definition limiting how much they can pay their employees. If the pay is low, the talent will go elsewhere. Banks as the new GMs and Chryslers? It’s not very far-fetched if the break-up-the-banks crowd gets its way.

Talent-free banks acting as utilities might appeal to some. They would even appeal to me in a certain sense. Bernanke et al told us that absent the bailouts of the banks that credit would dry up on the way to a staggering recession, but the real truth is that most finance and lending has long occurred outside the banking system. In that case, if politicians want the banking sector to resemble the U.S. automobile industry, fine.

The best financial minds will depart the banks in even greater numbers than they are, as will investment and deposits. Banks will become even more politicized in their lending because lacking talent and serious investment, they’ll only exist at the pleasure of politicians.

To the break-up-the-bank gang, seemingly all of this is ok because they want to put bailouts in the rear-view mirror. That’s fine, this writer does too, but they’re dreaming if they think bailouts will end simply because banks will have been broken up.

The reason for this is basic, though perhaps contrary to what most are used to reading. Put simply, banks aren’t heavily regulated because they’re not politically connected, in truth they’re heavily regulated precisely because they are politically connected. And because they are, connected banks will either skirt the rules on size or they’ll shrink their way to market irrelevancy; their ongoing existence a function of their ability to please their political masters.

In short, shrunken banks will face profit pressures for being made artificially small, for being less profitable they’ll be more reliant on their political angels, and when they inevitably fail due to smaller margins, politicized loans, and talentless management, their ties to the political class will ensure their ongoing survival. If government can force banks into lower margins, rest assured that it will pay when these politically potent entities start to implode. Conversely, if the feds look the other way as the banks merge again in order to compete, any failures will fall at the doorstep of a federal government that allowed all the M&A activity.  Hello bailouts yet again.

What’s comical about all this is how unnecessary it all is. Implicit in the break-up-the-banks mentality is that if a financial institution grows too large that its failure will send the economy into a multi-decade funk. The very supposition would be very funny if it weren’t so sad, and if it didn’t carry with it such dire, economy-suffocating implications. Many people in power do believe this narrative, including our present Fed Chairman. As Bernanke put it to then House Speaker Nancy Pelosi about propping up the banks back in 2008, “”if we don’t act in a big way, you can expect another great depression, and this time it is going to be far, far worse.”

Back to reality, for those fearful of one, ten or 100 financial institutions’ failures crushing the economy for decades, simply Google post-WWII photos of Japan and Germany. Both countries were literally reduced to rubble during the war, but within a few years of its end, and bolstered by falling tax rates alongside stable money, both country economies ascended to some of the world’s largest in fairly short order.

Despite what you hear from Bernanke, if Japan and Germany can emerge from total destruction in just a few years, our economy can surely survive the bankruptcy of Citigroup C +1.37%. In truth, our economy would in fact be much improved if Citi – bailed out five times in the last 22 years – were ultimately bought by management possessing a clue. And then if you believe that Citi’s decline would take other banks with it, please refer once again to pictures of Japan and Germany in 1945. The aggressive assertion from Bernanke, Paulson, Bush, Geithner, and Obama that our economy couldn’t survive the failure of poorly run financial institutions is easily one of the greatest, most economy-weakening lies ever foisted on the American people.

Back to why the ‘break-up-the-banks’ crowd misses the point, it does because fearful of the myth that is ‘systemic risk,’ it can’t bring itself around to the only banking fix that would solve its hatred of bailouts. Simply put, bank regulation should be limited to one line: if you fail, your failure will be born by management, shareholders, and corporate counterparties. If so, investors with money at risk would watch their investments in banks even more closely (figure equity holders are wiped out amid bankruptcies), and then the counterparties of banks would necessarily spread their risk around a bit more to avoid the pain of one institution failing. In spreading their risk around thanks to a lack of bank regulation, it’s possible – gasp – that some banks would shrink as a result. Maybe, maybe not.

Needless to say, one certain way to ensure that banks never shrink is to maintain the status quo that says ‘systemically important’ institutions and their counterparties will be bailed out. Just the same, it’s an even worse solution to break up the banks on the way to shrinking profits along with the talent inside them. All of which brings us to the only solution, which is to stop regulating them altogether. If so, as in if every financial institution and counterparty is participating in a real market, we might get what we’ve always wanted in terms of bank size, risk profile, innovation, and everything else that free markets always deliver without fail.

* Absent the bailout of Bear Stearns there’s no market expectation of further bailouts, thus making Lehman Brothers’ eventual implosion a non-event. Markets would have been prepared for what was ahead. But thanks to the interventions – from bailouts to curbs on short sales to the federal government’s generally muscular presence – a market correction followed by a shallow downturn was turned into a crisis.

(Source: Forbes)

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