BIG BANKS ARE NOT THE FUTURE / THE WALL STREET JOURNAL OP EDITORIAL ( A MUST READ )

OPINION
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June 5, 2012, 6:52 p.m. ET
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Big Banks Are Not the Future
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As leading financial firms face market and regulatory challenges, the likelihood of their managers responding deftly seems slim at best.
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By HENRY KAUFMAN
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The halcyon days of large financial conglomerates are over.



This assertion may seem surprising in light of the growing power—and profitability—of the leading financial institutions in recent years. The trend toward oligopoly, already in full swing during the 1980s and '90s, only accelerated during the financial crisis of 2008, as faltering firms were absorbed by a handful of burgeoning survivors.



Coming out of the crisis, those at the top seemed unassailable.



Today, a mere 10 highly diversified financial institutions are responsible for 75% of total financial assets under management. Not only are they too big to fail, if the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act works as intended, they are supposed to become more stable going forward.



Many observers therefore assume that these behemoths will dominate into the foreseeable future. Or will they? The same crisis that shrank the number of leading players also exposed many of their frailties.



Giant diversified financial institutions operate on both sides of the market—as portfolio managers and institutional investors on the buy side, as underwriters and dealers on the sell side, and as financial advisers on both sides. These conflicts, which are built into the firms' structures, strategies and decision-making dynamics, often bring them into conflict with the public interest.



The diversified financial giants also suffer from structural weaknesses that undermine the ability of their senior executives to govern them effectively. Increasingly, power resides in middle managers, who are highly motivated by various incentive formulas to take (sometimes irresponsible) risks. Top executives must navigate through a blizzard of arcane formulas and oversee activities in far-flung operating units in order to assess and manage overall risk properly. Because they often lack the time and tools to monitor diligently, they must rely on the veracity of others.

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Dodd-Frank includes various provisions to discourage recklessness among the giants, but regulation is not the solution. While enshrining the leading financial firms as "too big to fail," the new legislation imposes on them a long list of strictures—of "dos" and "don'ts"—for controlling their behavior. But a well-run financial system cannot be micromanaged through elaborate regulatory codes. As the trend continues—as the huge financial conglomerates operate under continuous and rigorous scrutiny—they will become financial public utilities. Meanwhile, the crucial job of competitively allocating credit will be relegated to a shrinking portion of the financial markets.

Imposing higher capital requirements on these big institutions also is not the way to go. Will such higher requirements actually remove or minimize the many conflicts of interest noted earlier? I don't believe so. Indeed, higher capital requirements may well encourage more risk-taking.



The power of leading financial conglomerates is being narrowed in other ways. Their inventiveness in introducing new financial products and marshaling new technology allowed them to outrun regulators for decades. The gap is now narrowing. Even though supervisory authorities initially were slow to perceive the implications of securitization and to respond appropriately to the rapid growth of derivatives, the landscape is much clearer now. In the wake of the 2008 crisis, neither regulators nor investors see these innovations as reliable ways to diversify risk. Large financial institutions will need to work hard to develop new techniques for expanding credit that are acceptable to regulators.



Information technology, once the handmaiden of leading financial conglomerates, now serves regulators. It is not difficult to imagine a day in the near future when credit flow information—data on trades, loans, investments, changes in liabilities, and so on—will flow instantaneously from financial institutions to official regulators.



In the somewhat more distant future, the entire demand deposit function probably could be taken over by governments through a network of computer facilities in "the cloud." Even more likely, within a generation branch banking will become obsolete as the general population (not just early adopters) conducts all its banking on hand-held devices. McDonald's or Starbucks or some other retailing chain will gobble up the bank branches for remodeling.



As leading financial firms have challenges to their dominance from several directions, the likelihood of their managers responding deftly seems slim at best. Change is seldom attractive for incumbents, especially when they enjoy such a predominant position in a major sector of the economy. Rather, shareholders need to push for action.



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The most critical measure shareholders should insist on is divestiture. The financial conglomerates need to shed some of their activities and become more focused. That strategy would bring several major benefits, for the firms as well as for our financial markets and our economy. It would reduce their operations to manageable proportions. It would declassify them as "too big to fail." It would lessen the role of government in the marketplace. And, in a win-win dynamic, it would enhance stockholder value significantly. All are reasons not to lament the sunset of the giant financial conglomerates.



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Mr. Kaufman is president of Henry Kaufman & Company Inc. and author of "The Road to Financial Reformation: Warnings, Consequences, Reforms" (Wiley, 2009).

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