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Should big banks be broken up?

The idea that some banks are "too big to fail" became common in 1984 when Continental Illinois was on the brink of failure. The then-seventh-largest bank in the U.S., Continental Illinois had $40 billion in assets, but many of those assets were bad loans, and investor fears of its failure led to a run on deposits that the FDIC responded to with an unprecedented bailout. The FDIC and other regulators feared the bank's complete collapse could lead to a larger financial crisis, and to avert that crisis, risk investors (bond holders) as well as insured depositors were bailed out.

This begs the question: How could a bank of this size have been considered pivotal to the entire U.S. financial system when total bank assets in 1984 were more than $2.4 trillion?

In 2008, Lehman Brothers was the third-largest investment bank in the U.S., with total assets of $639 billion when it filed for bankruptcy, and Bear Stearns was the seventh-largest investment bank, with $350 billion in assets when it was sold, under pressure from the Federal Reserve, to JP Morgan for $6 billion. Regulators also forced the sale of Merrill Lynch and Countrywide Mortgage to Bank of America. Again, "too big to fail" was a justification for these interventions. But no widespread panic or systemic failure occurred in traditional commercial banks.

In 2010, lawmakers claimed that the comprehensive financial regulation law known as "Dodd-Frank" would put an end to this flawed policy. However, the concept is just as prevalent today in the debate about large-bank regulation as it was in 1984 or 2008. The problem facing federal regulators is not that some institutions are so vital to the entire economic system that they must be bailed out at any cost, but rather that some institutions have so much entrenched market power and political influence that politicians and regulators will find it too painful to their own careers to take the difficult, but necessary, steps to liquidate these banks when they fail.

The Dodd-Frank law contained two provisions that were supposed to address the risk of systemic failures caused by these megabanks. One, called the "Volcker Rule," required banks to refrain from "speculative" trading that didn't benefit their customers. However, trading in derivative instruments such as financial futures is integral to a bank's proper risk-management activities, and regulators have been unable to write a rule that effectively eliminates speculative trading without harming legitimate risk management.

Another provision, known as the "living will" for banks, required banks to submit a plan for their orderly liquidation in the event of failure. The Federal Reserve and the Federal Deposit Insurance Corp. have the authority to sanction and fine banks whose "living wills" are not up to their standards. However, there is no agreement on what the standard for these plans should be, and recently the FDIC rejected the plans for 11 of the largest banks in the U.S. calling them "not credible."

From 1933 to 1999, banking regulations known as "Glass-Steagall" prohibited commercial banks from participating in securities underwriting and trading. This separation of banking from investment banking was necessary because these types of activities are very different in terms of their risk and the type of regulation they require. Traditional commercial banks have long been considered uniquely important to the economy, which is why deposits in them are insured by the FDIC. Investment banks, on the other hand, can fail without creating a general panic.

The most direct way to address the problems of regulatory complexity and systemic risk is a return to the Glass-Steagall prohibitions: Require commercial banks to divest their investment-banking divisions, so that each type of bank can be regulated appropriately.

Marcus Allan Ingram is chair of the department of finance at the University of Tampa.

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