Following the 2008 housing downturn and financial sector meltdown, measures were adopted to ensure that tax-payer funded bailouts of banks would never again be needed. The most significant legislation passed was the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. 

Among the law’s many provisions is the establishment by bank regulators of processes for the orderly liquidation of banks that face possible bankruptcy, such as requiring banks to submit living wills outlining how they might be dismantled. The law also includes measures to reduce the likelihood of big bank failures, such as subjecting large banks to stricter regulations. 

Unfortunately, progress in the past five years has been limited. A lot of the provisions of Dodd-Frank have yet to be implemented, and the public still seems to believe that the government wouldn’t let very large banks, like JPMorgan Chase (JPM - Free JPMorgan Chase Stock Report) and Bank of America (BAC -Free Bank of America Stock Report), fail. 

Adding fuel to the fire was JPMorgan Chase’s large trading loss as the result of the actions of a rogue trader (nicknamed the London Whale) at the company’s London office. JPMorgan had been viewed as one of the better-managed banks before the trading losses became public in the spring of 2012.  Investors wondered whether the company’s size contributed to the apparent lack of adequate controls.

Then in July of 2012, former Citigroup (C) chairman Sanford Weill did a surprising about face, and advocated splitting commercial banking from investment banking. Recall that Mr. Weill’s Travelers Group acquired Citicorp in 1998 to form Citigroup, a merger that led to the 1999 repeal of the Glass-Steagall Act of 1933, which separated commercial banking from investment banking. 

More recently, in March 2013, remarks by Attorney General Eric Holder highlighted the difficulty of bringing charges against large banks suspected of crimes due to their size and significant role in the economy, although Mr. Holder later indicated that big banks are not immune to prosecution.  Meanwhile, the protracted settlements of bank mortgage lending abuses have contributed to the notion that big banks can’t do anything right. Over the past year, all of these factors have led to a rise in calls to break up the largest banks. 

So, how will it all end? On a practical level, it would certainly be difficult and expensive to break up big banks.  And not everyone is for breaking up large banks. Federal Reserve Board Chairman Ben Bernanke has expressed his belief that Dodd-Frank needs to be given more time to work before considering more drastic measures to shore up the banking sector, like downsizing big banks, and instead he appears to favor forcing banks to build up their capital cushions to put the industry on a sounder footing.

In a March 25th article in the American Banker, Rob Blackwell lays out three possible outcomes of the renewed push to break up big banks. The first assumes that it would be difficult to push break-up legislation through Congress and that the break-them-up fever will eventually subside. The second acknowledges the possibility that another scandal in the bank industry, like the London Whale episode, could result in a surge of support from the public that might overcome opposition in Congress to efforts to split up large banks. The third, which he calls ‘’The Stealth Breakup”, suggests that the rising tide of regulation imposed on banks will eventually make it too expensive and burdensome for banks to be big.

Time will tell whether big banks will be forced to downsize. We don’t expect absolute size limitations on banks to be imposed. But regulatory fatigue might well discourage bank expansion. Note that in late May, a bill introduced by Senators Sherrod Brown and David Vitter, that among other provisions would require banks with over $500 billion of assets to maintain a 15% equity capital-to-assets ratio (well above current levels at most banks), represents just the type of regulation that might cause big banks to reconsider whether it’s worth their while to remain big. Most believe the bill probably won’t become law, but the move to resolve the too-big-to-fail problem has gained urgency recently and other efforts to ensure that big banks won’t again need to be bailed out could prove equally as burdensome.

Meanwhile, the move to curb bank size might have unintended consequences. If they are unable to increase earnings via expansion, banks might try to boost earnings by raising their participation in high-margined activities that are risky, or by charging more for bank services and loans. Some also question whether size limitations might put banks in the United States at a competitive disadvantage to foreign banks, many of which are much larger than U.S.-based institutions. These questions will have to be taken into consideration by regulators in their efforts to resolve the too-big-to-fail problem.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.