03/18/2010 05:12 am ET Updated May 25, 2011

Europe, the U.S. and breaking up the banks

Now it gets interesting. With the recovery at least beginning, European and now British regulators are clearly leaning toward a more competitive banking system with smaller players. The European Commission's Neelie Kroes' decision to break up ING Group NV (NYSE:ING) was the first major substantive move, but that was followed by the announcement that two of the largest recipients of U.K. bailout money (which was just hiked), Royal Bank of Scotland (NYSE:RBS) and Lloyds Bank ( NYSE:LYG), would make divestitures in response to EU pressure and that the government wants at least three new banks cobbled together from remnants of RBS, Lloyds and Northern Rock plc. All this puts comments by Bank of England chief Mervyn King about the need to break up too-big-to-fail banks and move toward some version of venerable Glass-Steagall and by Adair Turner, the U.K. head of the Financial Services Authority, on Tobin taxes in a whole new light.

As Simon Johnson says, there's an increasing establishment consensus in Europe and Britain that breaking up TBTF banks, with implicit or explicit backing by the government, into a more competitive banking sector makes sense. Johnson concludes: "The U.S. position on protecting everything about our largest banks is starting to look increasingly isolated and out of step with best practice in other industrialized countries. Time to start planning the break-up of Citigroup."

Well, actually, I thought Citigroup Inc. (NYSE:C) was supposed to be breaking itself up anyway -- though not in the way that Johnson finds necessarily satisfying. There's also a sort of rich irony in Johnson's notion that the U.S. should follow "best practice," since the system that still prevails, though it's eroding, worldwide -- bigger and more diversified is better -- has long represented best practice. By this point it should be pretty clear that the notion of best practice can resemble that of the conventional wisdom and needs to be tested in the marketplace.

Still, give the Europeans credit: They have moved to break the stranglehold on TBTF, and they have linked that issue to matters of competitiveness. All this is pretty bold. Whether those new banks in the U.K. will prove competitive in another way -- profitable, prosperous, capable of driving economic growth -- is another question. And perhaps we will now get to test the hypothesis, much debated currently, that advanced economies can get by without large global banking institutions.

As for the U.S., moving in this break-em-up direction may well be wise. But this market is very different from Britain and parts of Europe -- though arguably becoming less so. First, there is no EU applying pressure; the banking regulators in place are the ones that presided over increasing size in the first place and pulled the trigger on bailouts. Second, banking has traditionally been broadly decentralized in the U.S., with thousands of banking institutions scattered far and wide. Sometimes, crises can emerge from those smaller, and by definition weaker, institutions, as it did in the Great Depression and in the S&L mess. And while consolidation has significantly culled the number of banks -- and created a handful of megabanks with significant market share -- there continue to be thousands of banking institutions, plus large numbers of nonbank financing operations, out there. It's not as if the U.S. lacks what the Brits call "High Street" banks, though there has been a clear shift in power from local "independent" banks to the giants. It's easy to see how breaking up Citi or Bank of America Corp. (NYSE:BAC) would reduce TBTF. It's a little harder to see any dramatic effect of more retail institutions on the competitive landscape.

That doesn't mean breaking up the big boys shouldn't be done. TBTF is a chronic economic, financial and political problem.

But it bears repeating: Today's best practice is tomorrow's antiquated, and retrograde, ways. Eventually, the pendulum will swing from a focus on safety and prudence to efficiency and competitiveness -- that is global competitiveness, which is not the same as competitive retail banks putting pressure on fees. (It's also easy to glorify retail-oriented banks, which peddled a lot of the toxic mortgages. It was pretty competitive -- in the absence of regulation, destructively competitive.) This is the way things are, though that shift still looks a way off. But you will know we're making that move when you start to hear folks bemoaning the share price or earnings potential of a retail or High Street bank. And you will know we're swinging even further when stories about how "international" or "global," say a J.P. Morgan Chase & Co. (NYSE:JPM) or an HSBC Holdings plc (NYSE:HBC) has become and how the credentialed crowd is flocking to these high-status, world-class institutions.

Maybe, as Paul Volcker often counsels, the best strategy is to move slowly, carefully and thoughtfully. - Robert Teitelman

Robert Teitelman is editor in chief of The Deal.