06/08/2012 04:04 pm ET Updated Aug 08, 2012

Are Big Banks Dinosaurs?

Henry Kaufman, Dr. Gloom from a distant age when Salomon Brothers was still King of Wall Street, penned an op-ed in the Wall Street Journal Wednesday declaring that, sooner or later, the era of monstrous, too-big-to-fail banks will end. You can't argue with Kaufman's observations about their weaknesses: Diversified banks are riddled with conflicts (including, too often, with the public interest), too big and complex to manage effectively, and have found themselves increasingly hemmed in by what he calls "dos and don'ts" from re-regulatory efforts like Dodd-Frank. (And of course before that, he leaves unsaid, they had a slight tendency toward excessive leverage and risk.) More fundamentally, and more arguably, he believes the innovation gap between banks and regulators is shrinking and that "information technology, once the handmaiden of leading financial conglomerates, now serves regulators." Finally, he speculates that the government "in the somewhat more distant future" could take over "demand deposit functions" through computer facilities in "the cloud." Kaufman airily leaves a lot of details out, beyond the prediction that branches will be taken over by fast-food joints. And why would the government step in there? Why would the government want to force banks off stable, insured deposits and further into market financing? Would this include smaller banks? As we've seen with the likes of Goldman, Sachs & Co., you can clearly be TBTF without any insured deposits.

A few of Kaufman's asides are thought provoking. He doesn't believe piling up more rules really helps much of anything: "A well-run financial system cannot be micromanaged through elaborate regulatory codes," he writes, just as he's convinced that higher capital levies will only serve to fuel greater risk taking. What he doesn't note is how those two tendencies might work together. More capital drives greater risk taking, which fuels more rules and constraints, which accentuates the urge to seek greater risk. This is not a healthy dynamic, and eventually the whole thing blows up. In fact, that paradoxical drive to excess existed in the years before the crisis. New rules and greater capital levies were not the problem, but competition and shareholder pressures were. Competition exerted pressure on profits, which shareholders demanded. Result: greater innovation, risk and leverage. But as John Gapper argues in a Financial Times column Thursday on MF Global, market conditions after the crisis are far tougher than before -- and more conducive to size and diversification.

Kaufman believes the big banks are too dumb and too slow to adjust to changing times (although he admits they've also been pretty inventive, which makes for another uneasy combination). Thus comes his primary lever of reform: shareholders. Kaufman argues that eventually shareholders will tire of big-bank underperformance and force divestitures to regain "focus." He offers no timeline.

There's a lot to pick at here. Kaufman leaves out some crucial factors, including the market subsidy TBTF banks get and the clout their size and wealth provides when it comes to regulation and lobbying. You don't have to be in the Simon Johnson banks-as-oligarchs camp to realize that current big banks have a number of advantages over smaller institutions (one of which has traditionally been the Federal Reserve, whose powers have been amplified post-Dodd-Frank, and which has long favored dealing with a handful of large, global institutions). Moreover, Kaufman seems to believe that the activism that pushed Dodd-Frank through will continue into the future. And yet ardor for bank regulation -- despite J.P. Morgan Chase & Co.'s big trading boo-boo -- has significantly waned. That could evaporate if Republicans hold Congress or regain the White House. How can regulators close that technology gap with big banks when their budgets are threatened? Where's all this magical technology coming from, a yard sale?

What really is happening with the beleaguered banks? We have seen a long-term shift from larger banks in the '20s to many smaller banks through the '70s (Glass-Steagall, among other regulatory constraints) to massive consolidation after that, which has produced a far more concentrated banking sector than at any time in U.S. history. Is there evidence for a cyclical shift back to a more traditionally decentralized system -- or have the demands of an advanced economy in a highly technological, wired and global world shattered that possibility forever? When Kaufman talks about shareholders breaking up these financial conglomerates through divestitures, he seems to be recalling the rise and fall of corporate conglomerates -- ITT, LTV, Litton, Textron -- in the '60s and '70s. The growth of the conglomerates was fueled by the equity bull market of the '60s and the emergence of go-go investors, notably mutual funds. What sealed their fate -- commencing a several-decade-long process of "rationalizing" them -- was the vicious bear market of the '70s, which robbed them of the inflated shares they needed to build their intricate, if flimsy, constructions. This divestiture wave was urged on by many of the same shareholders that originally made conglomerates possible. Arguably, this episode represented the first large-scale restructuring sought by newly empowered institutional investors and the battleground where the first cries of shareholder value were heard.

It's unlikely that we will exactly replicate that de-conglomeratization process in banking. Up to this point, big banks have successfully convinced shareholders that the benefits of great size -- technology, capital, diversification by product and geography, market subsidies, political clout -- meant more than quite-evident conflicts, inefficiencies, leverage and risk. The corporate conglomerates were a kind of legal Ponzi scheme; they had to continue to grow (using that cheap currency) or they would crumble. Operationally and financially, banking conglomerates and corporate conglomerates are not quite the same; the banks need to find sources of profit in a commoditizing arena, but they don't necessarily have to pile up acquisitions to keep the music playing. Moreover, the role of institutional shareholders has subtly changed since the '70s. They are more broadly diversified and more open to risk (and reward) in some of their holdings to drive performance. The broad diversification of the modern big bank provides bankers plenty of places to move capital in search of profits. The structure of the big bank may be inefficient and Balkanized, but you can't discount the strengths as well.

This leaves us with unanswered questions. Will regulatory pressure effectively wring profits out of enough bank products to force the divestitures Kaufman describes? Will regulators be able -- or willing -- to close off all the high risk and reward options? Better yet, will they want to close all those holes? What will a big bank look like after this sheep-shearing process occurs, particularly if the government decides to go into the demand-deposit business? Wouldn't the drive to truly "safe" banking, once begun, go to naturally trap all banking products with any kind of risk into a swamp of rules, eventually creating utility-like banking? Will shareholders demand divestitures if that kind of blanket regulation, reminiscent of the Glass-Steagall era until the late '80s, doesn't occur? And will forcing banks to slim down and rationalize make them all that better performing from an investor perspective?

These are a lot of questions, none of which can be answered today. The financial arena remains fluid and uncertain and the future is opaque. Kaufman may long have had a reputation for being a market seer, if such a thing really exists. But this bold prediction seems to be based more on intuition than argument. Getting rid of the big banks won't be that easy.

Robert Teitelman is editor in chief of The Deal magazine. This post originally appeared here.