What Breaking Up the Banks Wouldn't Fix

Nearly a decade ago, as the entire financial system was collapsing, the bank where I worked, Citibank, was deemed too big to fail. Many other banks were also in the same situation, and also bailed out and allowed to live. And live on they do. Today Citibank, and the other banks, are just as big.

This is causing some policy makers to worry. Neel Kashkari, who helped structure the bailout, is now president of the Federal Reserve Bank of Minneapolis. On Tuesday he gave a speech, stating that those big banks pose an “ongoing risk to our economy.”

It was an impressive speech and surprising given his past as both a Goldman Sachs banker and as a “free-market” Republican. It also angered many bankers and politicians, because he voiced a secret of Wall Street: Despite Dodd-Frank, despite claims to the contrary by some politicians, “the largest banks are still too big to fail (TBTF).”

One of his proposed solutions—breaking up the banks—puts him in the same company as Bernie Sanders and a handful of other politicians. Doing so would go some of the way toward improving bank governance: If the government turns Citibank into ten smaller Citibanks, they will probably be better managed, since too big to fail is also too big to manage. Additionally, some might start doing things differently from the rest, even innovating.

But it wouldn’t address the other major ongoing failure of our financial system, namely that banks are taking on too much risk, and in the process endangering the entire economy and necessitating occasional bailouts. When the economy gets into trouble those 10 smaller Citibanks will probably all get into trouble exactly at the same time, requiring 10 smaller bailouts, or one large bailout of the “markets.”

It's crucial to remember in all of this that banks are not just victims of economic downturns—they also cause them with their reckless behavior. To stop that government needs to address their compensation structure, not just their size. Bankers today have little financial interest in their banks’ health, which leads them to irresponsible behavior.

The old Wall Street, prior to 30 years of deregulation, was filled with partnerships. Employees were required to keep their money in the company, so if the firm failed, bankers failed, resulting in a degree of self-policing. Wall Street bankers were personally invested in the strength and integrity of their decisions, because if they went wrong, they themselves lost big.

Bankers today get paid mostly in cash bonuses. Many on Wall Street, certainly those who work at the big banks, have a fantastic win-win deal: They get paid if they win and they don’t have to give anything back if they lose. Often, the incentives are actually structured to encourage taking on reckless levels or risk.

That was certainly the case during the run-up to the financial crisis 10 years ago. Not only did nobody go to jail for the crisis, not only did few lose their jobs, but the real dirty secret of Wall Street is that many of the bankers did very well because of it. I know: When Citibank was plummeting towards bankruptcy I assumed I would lose my job. When our stock fell below three dollars per share, I texted my wife, “ready to become farmers?” I didn’t have to become a farmer, and neither did anybody around me. Thanks to a government bailout, not only didn’t we lose our jobs, but we also got paid well over the next few years. Really well.

The crisis was good for many bankers, and not just the ones who bet against housing blowing up like in The Big Short, but for many who had behaved recklessly, and were responsible for the crisis. Including some of the CEOs of banks that got bailed out or blew up. That needs to change, by forcing bankers’ compensation to be locked up in the company and letting them know they will face prosecution for any crimes.

Both are central to a word that didn’t appear in Kashkari’s speech: fairness.  A system that bails out bankers, that doesn’t impose costs on them (money or jail), and actually rewards some of them, is simply unfair. Breaking up the banks won’t stop the bailouts, because banks are still incentivized to behave badly, and that’s true if it is one big bank, or 10 small banks. Bankers, when they fail, need to lose their money, their jobs, and sometimes, their freedom.