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Should “too big to fail” banks be broken up, or just discouraged from growing?

Yesterday, outgoing Bank of England governor Mervyn King called on UK legislators (paywall) to split up the Royal Bank of Scotland. The UK government owns 82% of RBS after taking it over in 2008, but King says that regulators severely overestimated its value, and aren’t going to get their money back as things stand. Instead, he suggests, it should be separated into a “good” bank—which could be sold back to the private sector—and a “bad” bank. King argues that the good piece would be more beneficial to the UK economy than RBS in its current form.

King isn’t the only one advocating a government-led bank break-up. In February, chancellor George Osborne pledged to truly split up the operations of banks that didn’t comply with new regulations. If a bank flouted rules on “ring-fencing,” or shielding day-to-day activities from riskier ones like trading and investment banking, Osborne said the government would have the ability to break up a firm into separate companies as a sort of punishment.

King’s recommendations—even though they face serious obstacles to actually getting passed—epitomize the differences between how British and American authorities are treating the “too big to fail” problem. Whereas the US has focused on creating incentives for banks to cut back—such as making big banks hold on to more capital even than the global Basel III regulations would require—the UK has espoused a more aggressive, top-down approach to stop institutions growing out of control.

Statements from the outgoing BoE head are almost directly at odds with those Federal Reserve chairman Ben Bernanke made consistently throughout the crisis: We have not and will not nationalize the banks, and we will let the market break up too-big-to-fail banks rather than do it ourselves. Contrast RBS with Citigroup: At one point, the US government owned as much as 40% of Citi, yet repeatedly refused to consider “nationalizing” it, at almost exactly the same time as King was saying that RBS and Lloyds were nationalized in all but name. And while Bernanke supported a plan to help Citi divest assets by splitting its core operations from its toxic businesses, the latter never stopped being a part of Citigroup. Citi paid back its debt to the US government in full in late 2010.

But new domestic regulations say even more about the differences in the US and UK approach. New banking rules in the US and EU will bar—or at least, seriously curtail—banks’ abilities to trade securities or engage in, say, private equity investments with depositors’ money. But to date, those rules don’t give regulators much power to step in and disband a bank. For example, Section 121 of the 2010 Dodd-Frank Act allows a two-thirds majority of the Financial Stability Oversight Committee (FSOC) to order a bank operating in the US with assets of more than $50 billion to discontinue certain operations or limit acquisitions; but it’s not really set up for the purpose of breaking down banks solely because they are very large institutions.

Instead, ending “too big too fail” in the US is all about making banks hold so much capital that they’ll choose to divest certain activities, because the cost of continuing them is so costly. (We’re not sure they’d actually go through with it, but that’s the theory.) “I think regulators could raise capital to the extent that it’s so expensive that [banks] just can’t operate [as they are],” says Kevin Blakely, a former regulator for the Office of the Comptroller of the Currency. “It wouldn’t take too much more before they decide to shrink their balance sheets.” This, Blakely explains, is far more likely than the US Congress passing a law against “too-big-to-fail” banks.

Anecdotal evidence would appear to bear this out. In a conference last month, Goldman Sachs CFO Harvey Schwartz told bankers that Goldman had considered dropping its mortgage securities business because of regulations that would have forced it to increase capital in this unit by 260%. “Under that capital proposal, we would have needed to exit [the] business completely or at a minimum, dramatically shrink it. There was no amount of efficiency or reengineering that we could have undertaken to make that business sustainable under the proposed rule set,” Schwartz said.

In the end, the regulations ended up being less stringent, forcing Goldman to increase capital by 170%, and so it decided to remain in the business. But other banks, Schwartz warned, might not make that same decision. “It feels like we’re in a part of a cycle where the competitive dynamic is such where people will actually exit businesses.”

From a theoretical perspective, the US approach may be a better one in the long term. As the memory of the financial crisis fades, we can probably expect regulators and legislators alike to ease up on the banking industry. In Britain, diminishing political will for reform means legislators may not use their powers to actually break up banks anymore. Capital requirements like those the US has adopted are probably more durable. Whether good incentives work or not…well that’s another story. (Hint: Goldman is already taking advantage of all the loopholes).

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