02/01/2012 12:15 pm ET | Updated Apr 02, 2012

Christopher Whalen and the Bet on Small Banks

The New York Times' DealBook offers a jolly sendoff to Christopher Whalen, the analyst at Institutional Risk Analytics who has been predicting the downfall of the big banks for a number of years now. For a while there, Whalen was ubiquitous, testifying in Congress and getting widely quoted in the financial press. Now he's making the move of other analysts tossed aloft by the crisis for their bearish calls -- Meredith Whitney and Nassim Taleb in particular -- by putting his money (or rather investors' money) where his mouth is: He's setting up a fund to invest in smaller banks at Tangent Capital Partners.

Who knows? Whalen may turn out not only to be prescient, but to be an excellent stock picker as well. Still, there is a big difference between his critique of the big banks as an analyst -- driven initially by his belief in the dangers of subprime, then, more recently, by his argument that continuing mortgage losses and endless litigation would force a breakup of the big banks -- and his championing of smaller banks and traditional banking practices. There's no doubt that the big banks, particularly Bank of America, are under great stress stemming from the real estate collapse. But the argument that as a group -- including J.P. Morgan Chase & Co., Wells Fargo and Citigroup -- they will be broken up depends on two articles of faith: that the mortgage crisis, and its backwash of litigation, is still far greater than consensus estimates and that the forces of re-regulation will eventually resolve too-big-to-fail by carving up the banks. Currently, neither of those possibilities seems at hand, at least in the near future. Besides, if a still-hidden mortgage cancer does erupt, it will upend smaller banks as much as the big boys. And a move to break up the big banks, presumably by reprising a form of Glass-Steagall split between commercial and investment (or merchant) banking would not directly help smaller banks. The fact that the Volcker Rule, just about the only structural remedy in Dodd-Frank, is mired in criticism, including from our closest allies like Europe, Canada and Japan, as Andrew Ross Sorkin notes today, suggests how difficult it will be to do something more draconian.

But let's get very basic. The question raised by Whalen's move is: How profitable can traditional commercial banking be? Historically, the cries for deregulation and M&A-driven consolidation in banking began in the '80s when bigger banks began to complain about disintermediation, that is, the business lost to a variety of new, deregulated competitors such as mutual funds and investment banks. The cost of banking was increasing and profits were falling. Traditional bank products, from mortgages to commercial loans, were getting squeezed. Regulation made any kind of response difficult. And talent was flowing toward firms and funds that could pay a lot more than traditional commercial banks. The breakdown of Glass-Steagall is often blamed on greed, free-market ideas or the rise of shareholder value (in an interview with Bill Moyers this weekend, former Citibank CEO John Reed blamed it all on Sandy Weill's belief in shareholder value, although it began many years before Weill came near to banking or convinced Reed to merge his bank with Travelers); while all of those factors were at play, the underlying debility of traditional banking as a business was a harsh reality that explains all kinds of disasters, from the LDC loan debacle (led by Walter Wriston's Citi), to the S&L crisis to the first stages of consolidation and the breakdown of the regional compacts (it may also explain Reed's own brush with a lending disaster at Citi in the early '90s, which he engineered without Weill). In the '90s, the old J.P. Morgan & Co. launched the most dramatic attempt to escape what it viewed as the trap of traditional commercial banking: its long march to build an investment banking operation, first in Europe, and then with the Federal Reserve incrementally deregulating, in the U.S. under Section 20. J.P. Morgan ended up getting swallowed by Chase Manhattan in 2000.

The rest of this history has been told often enough. The point here is that in a globalizing, increasingly technological industry operating in a national market and made up of public companies with performance-driven shareholders, making the kind of money necessary to drive a share price in commercial banking is very tough. It's the reason so many banks sell out to bigger rivals. Has anything changed in this regard since, say, the mid-'90s? Certainly, technology has grown cheaper and more standardized. But that simply levels the playing field, further commoditizing traditional banking products. Disintermediation still remains. There are fewer banks, it is true, but compared to other developed countries, there remain a lot of them; it's a very competitive business. Worse, the Internet further reduces any chance for a local bank to control its own territory. Smaller, local banks may have a better understanding of local markets, though historically, whether in the S&L debacle or the mortgage crisis, smaller banks collapse in larger numbers than their bigger (yes, protected) brethren. Particularly when it comes to real estate, familiarity with local conditions and a desire to serve local customers may lead to a kind of hubris.

The bottom line: It's brutally difficult to make much more than a decent living in a traditional bank, no matter the nostalgia for It's a Wonderful Life or your disdain for the plutocratic ways of the big banks. Unless we somehow reduce the relentless power of disintermediation, not to say TBTF, economies of scale and the Internet, smaller banks will resemble the always-endangered, much-romanticized family farm. The personal touch is nice, but it's an uphill battle economically, particularly when the weather shifts.

Does that mean Whalen is fated to fail? Not necessarily. There are thousands of banks out there, big, medium-sized and tiny, and that offers a diverse field for a stock picker with deep knowledge. Bank consolidation remains a reality below the top banks, which can be played betting on buyers (including a few private equity firms) or sellers. There are undoubtedly some superbly run smaller banks, though they'd probably be among the consolidators if they don't get taken out. What Whalen's move doesn't say is that traditional banking is about to make a comeback, even if the big boys get shattered into a hundred pieces. Traditional banking is a difficult, commoditized service business, shorn of products that make fat profits. That's the reality that no one ever speaks of when they cry out to revive Glass-Steagall or when they wax poetic about the joys of small-town banking.

Robert Teitelman is editor in chief of The Deal magazine.