"Too big to fail" is too big

Jim Jubak's latest column is a pretty convincing explanation of Why Big Banks Hate Banking. He runs through several examples (Goldman Sachs, JP Morgan Chase, Bank of America, Wells Fargo) showing that these companies may be involved (to varying degrees) in regular banking activities, but at least recently, they've been making most of their profits trading.

This wouldn't have been a big deal 10-15 years ago, when commercial banking and investment banking were separated, at least to some degree, by legal restriction. In those days, if investment banks wanted to risk their capital and lost it, tough luck. The problem is that these days, if these banking behemoths make bad bets and lose, they don't go belly up - the government (i.e., you) is on the hook for the losses.

In Thursday's Financial Times, columnist John Gapper took a look at the evolution of trading at Goldman. In the two years just before its 1999 initial public offering, when Goldman was still a private partnership - and any capital it risked came out of the pockets of Goldman partners - trading contributed about a third of its revenue. By 2006 and 2007, when a public Goldman was using money it raised in the public markets, trading revenue had climbed to two-thirds of Goldman's overall revenue. In the first nine months of 2009, when Goldman started using taxpayer money to take risks, trading revenue is up to 78% of revenue, Gapper figures.

It shouldn't exactly come as a surprise to you that Goldman Sachs is willing to put more capital at risk when the capital belongs to taxpayers (and, before that, to public investors) than when it belonged to Goldman partners.

And, of course, now that Goldman Sachs is a bank holding company, it can borrow some of that risk capital directly from the Federal Reserve.

Jubak ends his column wondering "why would the CEO of any financial institution big enough to be a significant trader decide to be "just" a traditional banker?" It's a good question. In fact, so good that some other heavyweights have been wondering the same thing.

Enter "Tall Paul" Volcker, former Federal Reserve Chairman, and supposed adviser to President Obama. Volcker wants to roll back the clock and separate commercial banking from investment banking once again:

Mr. Volcker's proposal would roll back the nation's commercial banks to an earlier era, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities.

The Obama team, in contrast, would let the giants survive, but would regulate them extensively, so they could not get themselves and the nation into trouble again. ...

Mr. Volcker argues that regulation by itself will not work. Sooner or later, the giants, in pursuit of profits, will get into trouble. The administration should accept this and shield commercial banking from Wall Street's wild ways.

"The banks are there to serve the public," Mr. Volcker said, "and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties" and ultimately fails.

The only viable solution, in the Volcker view, is to break up the giants....

In the Volcker resurrection, commercial banks would take deposits, manage the nation's payments system, make standard loans and even trade securities for their customers - just not for themselves. The government, in return, would rescue banks that fail.

On the other side of the wall, investment houses would be free to buy and sell securities for their own accounts, borrowing to leverage these trades and thus multiplying the profits, and the risks.

Being separated from banks, the investment houses would no longer have access to federally insured deposits to finance this trading. If one failed, the government would supervise an orderly liquidation. None would be too big to fail - a designation that could arise for a handful of institutions under the administration's proposal.

It's an interesting debate. On one side, the Obama Administration, the Federal Reserve Board, most economists, and the banks themselves. On the other, Volcker and a handful of other prominent economic names (Mervyn King, Governor of the Bank of England, being a big one who added his voice in support of Volcker's ideas last week).
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Mark Biller is Sound Mind Investing's Executive Editor. Visit www.soundmindinvesting.com to learn more.