Critics lay into bank breakup proposal that surfaced at Minneapolis Fed

Large banks stand squarely against any proposal that would break them up, and their man in Washington, D.C., former Minnesota Gov. Tim Pawlenty, jumped into the fray Tuesday morning.

Pawlenty, now head of the Financial Services Roundtable, laid out a message that has become the mantra of the financial industry and many within the economic discipline: that financial reform since the crisis, specifically the Dodd-Frank Act, is already working.

"There's more capital, more cushion, two or three times more than in these banks before the crisis, more oversight, living wills, provisions to wind down and allow institutions to fail, taking out their management, taking out their shareholders, and making the industry pay for failures," Pawlenty said on CNBC. "All of that's what's on paper in Dodd-Frank and the people in the Obama administration says that ends too big to fail."

But it doesn't take a bank lobbyist to punch holes in a proposal to break up the banks.

At Minneapolis Fed President Neel Kashkari's first symposium on the topic of too-big-to-fail financial institutions and the risks they pose to the nation, headliner Simon Johnson, an MIT economist, suggested a cap on assets for banks of 2 percent of U.S. GDP, a limit that would force several large banks, including Wells Fargo, U.S. Bank and Bank of America, to break up.

Critics laid into the idea.

Joseph Hughes of Rutgers argued that banks have a strong business case for being large because it gives them economies of scale. Gene Ludwig, a consultant to the financial industry, said the topic needs more study. Patrick Kehoe, the Minneapolis Fed economist, likened the idea of breaking up the big banks to throwing a hand grenade at a beehive after getting a bee sting.

The economist with the clearest objections was Aaron Klein, of Brookings, who questioned how large banks would be cut in size without damaging consequences.

Since the crisis, large banks have attracted small depositors much more quickly than small institutions. Big banks have better technology than their smaller counterparts. Finding a way for them to offload large chunks of customers in a fair way would be extremely difficult, and many people will not want to find a new bank, Klein said.

"The split-up process is going to be messy, because banks will want to shed their least-profitable consumers. But regulators have fair lending and the Equal Credit Opportunity Act, and for those of you who've been in this room who've had to decide whether or not banks can close branches, it is not a simple question. And so there'd be a giant push-pull between industry and regulators as to how they get smaller," Klein said. "It becomes very tricky there and those are very important issues in terms of access because people want these larger institutions."

Klein also pointed out that large global businesses — he mentioned 3M Co. by name — would have to figure out new ways to move money across worldwide operations. They could use a lot of small banks, which would cost more money, or they could start using giant foreign banks, which Klein said would not eliminate risk to the U.S. economy.

A big-bank breakup could also affect U.S. capital markets, Klein said. He said we won't know the cost of a restructured system until someone lays out the specifics, but a bank with assets capped at 2 percent of GDP might have trouble doing as much investment banking as the large banks do now.

Klein's last point was the same as Pawlenty's. He said he needs more proof that Dodd-Frank isn't working. "We cannot look at the financial regulatory system going into the crisis and compare that to what we see today," he said. "There was a giant sweeping change in between."

Any new plan must be either a substitute, rejection or complement to the Dodd-Frank legislation. "What you can't do," Klein said, "is ignore the fact that Dodd-Frank made a difference."

Kashkari also appeared on CNBC Tuesday, encouraging people to pay attention to the symposiums, calling Monday's discussion "vibrant," and insisting that — contrary to some of the criticism he has received in Washington and New York — no conclusions have yet been drawn.

Adam Belz • 612-673-4405