08/07/2012 12:24 pm ET Updated Oct 07, 2012

Sandy Weill's Bank Breakup Hindsight isn't 20-20

Sanford "Sandy" Weill, one of the individuals at the forefront of the Glass-Steagall Act repeal in 1999, sent waves through Wall Street when he recently changed his position. In a CNBC interview, Weill not only called for the banks to be broken up, but he said generally that the repeal of Glass-Steagall was, "right for that time," but that now times have changed and it no longer works.

I respectfully disagree with Mr. Weill. I contend that it should have never been repealed -- it didn't make sense then and it was a catalyst for creating the situation we are in today. However, the bed has been made and now it's too late to just undo it and suppose that we can go back to the way things were.

An Interconnected System

Looking at the mega-financial institutions that are "too big to fail," there are a number of issues creating the risk. This is not just risk from the integration of the investment banking and commercial functions, but systemic risk from the interconnectedness of major financial institutions globally, as well as the scope of each individual business.

The financial companies globally are like a bunch of kids at summer camp that live together in a cabin. If one kid gets sick, everyone's going to catch the ailment because they are all sharing the same housing (amongst other things).

Now that we are operating globally on a large scale, reinstating Glass-Steagall or something similar would also put US banks at a disadvantage versus other major foreign financial conglomerates. But perhaps more importantly, the US government can't legislate what foreign institutions do and if the foreign institutions "fail," the fallout will still reach the US, particularly in those companies that have exposure to those foreign entities. Given the interconnectivity of the financial system worldwide, all global participants have exposure to each other and therefore, should play by the same rules.

The AIG Argument -- In Too Big to Fail, Big isn't Limited to Just the Mega-Banks/I-Bank Hybrids

Separating commercial and investment banking kept mega institutions from being formed by some companies, but others gained scale anyways. Neither Bear Stearns nor Lehman (both casualties in their own way of the 2007/8 crisis) had commercial banking operations. AIG, which received a 9-figure bailout (the largest in history) and continues to be a taxpayer burden (AIG still owes the Treasury $36 billion, according to TARP's Christy Romero), is neither a commercial bank nor an investment bank; it's an insurance company. AIG got itself in trouble by selling Credit Default Swaps (insurance on mortgage derivative products), much of which it ironically sold to hedge funds and institutions that didn't own any mortgage products (but were rather taking a bet on the collapse of the industry). A bank breakup still doesn't prevent that from happening.

What's "Investment Banking" Anyways? | Volcker-Schmolcker

If we were to consider breaking apart commercial and investment banking functions again, we need to consider which functions and why. Investment banks perform many activities that have little to no effect on depositors' funds and are low risk. Mergers and Acquisitions advisory is an investment banking function, as is underwriting private and public equity and debt securities. None of those functions have much financial risk vis-à-vis deposits, so why call to separate those? Making markets may create some additional exposure, but the truly risky behavior stems from proprietary trading (which so happens to be a potentially and historically very profitable arena, as high risks can produce high rewards).

So, if you go back to something more like a Volcker Rule (however that rule ultimately ends up being defined) that limits proprietary trading by banks, you still have to contend with issues regarding the efficacy of legislation. First, legislation by its nature is backwards looking and the brains on Wall Street will always find a loophole around it. This is coupled with a second issue, which is that the people who write the legislation (i.e. our government officials) often are poorly educated on financial matters and rarely write effective legislation.

The Burden of Being Public

Another big question around the post-Glass-Steagall financial system that I would pose is: should firms that have both traditional and investment banking businesses even be public? In 1999, around the same time as the Glass-Steagall repeal, Goldman Sachs went public, which is debatably another catalyst to the state of our modern financial system and another enabler of the kind of "financial entrepreneurship" that Glass-Steagall was also credited with.

Being public creates burdens on companies to continue to grow revenue and profits every quarter or suffer at the hands of the market, which has a decidedly short-term view. This burden is an enabler for more proprietary trading and risk taking.

Moreover, the transparency and exposure to the market creates an exponential panic factor any time a mega-banking company has an issue. Sometimes, in making markets or trades, liquidity becomes an issue. In a private setting, a company can raise temporary or permanent capital without creating undue concern. However, when a public company has this issue, short sellers create stock pricing pressure and make it much more difficult to raise capital and rectify any liquidity situation. At the same time, individuals may panic and send more shocks through the financial system. This issue then creeps into other mega-banks, who are guilty by association in the market's eyes (i.e. if X bank is having issues, Y bank must be too). This can create problems, even if there is no problem with anyone else -- in the market, perception can become reality. This very issue caused the SEC to temporarily ban short selling on 799 financial institutions for three weeks in the fall of 2008.

Perhaps the answer is for commercial and investment banking hybrids to not be public. And if not, does that need to be legislated or will the markets ultimately drive the solution? Clearly, these mega-financial firms are much more risky than investors initially thought and their valuations are showing that. Most of the top financial institutions are trading below tangible book value (the value of the company's equity or tangible assets -- which excludes goodwill, etc. -- minus liabilities), that is, assuming that the tangible book values as reported are trustworthy (which, given the accounting rules for complex financial products, marks to market and off-balance sheet transactions, they may arguably not be). Goldman Sachs ($GS) is trading around 0.8x tangible book value; Morgan Stanley ($MS), Bank of America ($BAC) and Citigroup ($C) are each trading at around half of their respective tangible book values currently.

While certainly return on equity has slid in the sector, the current valuations also indicate that the market may not be fairly valuing the sector. This may create an opportunity for private, sophisticated investors to take these institutions private. If so, the side effect may be taking them away from the type of scrutiny that creates additional risk in the system.

Too Big To Fail = Too Complex for a Simple Solution

While the repeal of Glass-Steagall was certainly a part of making our system fragile to the point where it is at today, thinking that a simple solution like breaking up the banks will be the panacea that we seek is incredibly naïve. Something needs to be done, but the scope and the mechanism -- whether through legislation or market forces -- is something that needs some careful thought and a whole lot of strategic insight.