Eminent sense about TBTF..it sux

WSJ:

Tom Frost: The Big Danger With Big Banks

Taxpayer safety nets such as the FDIC should be available only to banks that are in the loan business, not those in the investment business.

Once upon a time, banks which took deposits from clients, also known as the average Joe, simply could NEVER USE depositor’s money for investment purposes. The entities which did that were, like Merrill Lynch, partnerships which solicited money, and then used that private partnership money at risk for investments. If THEY made a mistake, their money, the partner’s money, that is, and the voluntary investor’s money was lost and they might go out of business. Even more, banks which took depositor’s money and risked that on loans, were further restricted from risking that insured deposit money by rules which limited the circumstances under which they could make those loans. That was known as Glass-Steagall.

In the early 1950s, when I was a young college graduate and a new employee of the Frost Bank, my great-Uncle Joe Frost, then CEO, told me that the very first goal we had was to return the deposits we received from customers.

Our obligation was to take care of the community’s liquid assets and manage them safely so others could use them (via loans) to grow.

Frost Bank was not big enough to be saved by the government, Uncle Joe told me at the time, so we would always need to maintain strong liquidity, safe assets and adequate capital. I was impressed that making money was not high on his list of priorities, but he implied that profits would come if we observed sound banking principles.

When we look at banking in the United States today, Uncle Joe’s values seem so long ago and far away. The industry is now dominated by a few large banks.

In 1970, according to data from the Federal Reserve Bank of Dallas, the five largest U.S. institutions owned 17% of banking industry assets; in 2010 that share was 52%. Their business has expanded well beyond the role as steward of the community’s assets into riskier endeavors that chase supersized returns.

As the financial crisis of 2008 showed, the very diversification, structure and size of most of our largest banks put the community’s assets at tremendous risk. They had become “too big to fail,” and the government—really the American taxpayers—had no choice but to keep their colossal mistakes from bringing down the economy.

But as Harvey Rosenblum, the Dallas Federal Reserve Bank’s executive vice president and director of research, wrote last year, “These rescues have penalized equity holders while protecting bondholders and, to a lesser extent, bank managers.” In other words, by protecting people from the consequences of their errors, the bailouts raised the risk that the same errors will be made in the future.

There are many good proposals for minimizing, if not entirely eliminating, the likelihood of another “too big to fail” crisis of the sort we faced in 2008. Perhaps most prominent among them is the recommendation that we require banks to hold additional capital to protect themselves (and the rest of us) from loans and investments gone sour.

But even these recommendations would allow the big banks to keep their traditional FDIC-insured deposits, alongside their investment enterprises within the parent company. I suggest that we divide the two functions into separately owned, managed and regulated entities. That’s the only way we can ensure that their riskier businesses don’t undermine the insured deposits that are the foundation of a stable and healthy economy.

Taxpayer safety-net programs, such as the Federal Deposit Insurance Corporation (FDIC), should be available only to banks in business to provide insured deposits. Financial institutions that provide primarily investment, hedging and speculative services don’t deserve protection either by the FDIC’s explicit guarantees or by an implicit understanding that taxpayers will bail them out because there is no other alternative. Indeed, this kind of protection is a perversion of capitalism and can distort its good outcomes.

Uncle Joe was not a fan of the FDIC—he said it took his money to subsidize his inefficient competitors. I support the FDIC as a protection for the depositor, but, with a nod to my uncle’s wisdom, I believe this safety net should apply only to banks that are allowed to receive FDIC-insured deposits.

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We are approaching a state of affairs in which an oligopoly of a few major institutions dominates our entire banking system.