U.S. lawmakers are looking at ways to limit the damage that large banks, insurers and funds can wreak on the financial system, but breaking up healthy companies is unlikely to be part of the mix because it is too difficult to implement.
The Federal Reserve already has the authority to force banks to shed businesses that pose a risk to the banking system, but that power is rarely, if ever, used.
The issue of breaking up banks deemed "too big to fail" has been discussed for months as lawmakers and regulators look to reduce the chances of a meltdown like the recent financial crisis, which cost taxpayers hundreds of billions of dollars and hobbled major financial institutions.
It flared up again when U.S. Representative Paul Kanjorski added an amendment to proposed financial reform legislation allowing regulators to break up healthy companies that posed a risk to the financial system.
On Wednesday, the House's lead financial rule-writing panel voted to approve the amendment, and it may well pass the full House. But it is seen as less likely to make it through the Senate. And even if it does, regulators are unlikely to use their new power, analysts say.
Although experts may continue to discuss the idea of breaking up large, healthy institutions, many argue it deserves to die because of the myriad logistical obstacles.
"Capping the size of financial institutions is just the wrong thing to do," said Dan Alpert, managing director at boutique investment bank Westwood Capital.
One problem is determining which institutions are too big to fail. If a major bank were split up, the individual businesses might still be too big to fail, and those units would in turn have to be divided. Determining how to best divide them is difficult.
Meanwhile, a number of businesses that did not seem systemically important five years ago were in fact critical during the credit crunch. A good example is the bond insurers, which were seen for years as small companies interesting mainly to short-sellers. That changed in early 2008, when bond insurers' difficulties suddenly seemed important to the entire financial system.
"The whole idea of a top 20 list of financial institutions that are systemically important does not make sense, because No. 21 might have problems, and that might create problems for Nos. 1 and 2. It's not always clear who is too big to fail," said Christopher Laursen, a senior consultant at NERA Economic Consulting who previously worked at the Federal Reserve.
Another possible problem in breaking up healthy financial institutions is capitalizing the parts. A company's individual businesses may need more capital if they are separate than if they are together, said Tanya Azarchs, a bank ratings analyst at Standard & Poor's.
"The market is more tolerant of lower capital levels for a company if there is more diversification," Azarchs said.
Diversification makes a financial company's earnings more stable — when one business is weak, another may be flourishing. Regulators don't give financial companies credit for diversification, but investors and to a lesser extent rating agencies do.
So regulators breaking up a company may also have to figure out how the resulting businesses will raise capital. Convincing investors to provide more equity may be difficult.
"You're breaking up a company because you're concerned it will hurt the financial system, even though to everyone else it seems healthy. Is that a good story to tell investors?" said one hedge fund manager.
Breaking up healthy companies may not make sense, but few analysts dispute that the government needs a way to break up large financial firms on the brink of collapse.
The regular bankruptcy process is not ideal for winding down a major bank in a way that minimizes the impact on the financial system, as evident from the demise of Lehman Brothers in September 2008.
And some experts believe breaking up even healthy banks may be a good idea.
Large banks can help companies and governments globally raise capital, but the financial crisis revealed the enormous cost of that benefit, said Steve Kohlhagen, who built the derivatives business at First Union and later Wachovia.
Even if the United States is the only country to break up its banks, and foreign banks start winning more global business, over time smaller institutions will prove to have an advantage, Kohlhagen said.
"There's a cost, but in the long run I think breaking up institutions is the only way to do it," he said. Breaking up large institutions makes sense if Americans are generally uncomfortable with taking over large failed institutions from time to time, he added.
But to many analysts, the seemingly simple fix of breaking up big healthy institutions is anything but simple.
"Breaking up these institutions is not an easy thing to do, and if it's not done right, it could create an unlevel playing field based on potentially arbitrary criteria," said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a research and consulting firm focusing on political and regulatory risk.
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