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May 23, 2012 JPMorgan (JPM) Chase & Co. s colossal $3 billion-and-countingtrading blunder has breathed new life into long-simmering calls tobreak up big U.S. banks. We agree they ve become too concentrated,too complex and too unwieldy to effectively regulate or manage, butthere are better solutions than asking bureaucrats to take themapart. The biggest U.S. banks have grown only bigger since the financialcrisis. The five largest institutions now control 52 percent of allthe banking industry s assets, up from 17 percent in 1970.JPMorgan alone holds more than $2.3 trillion, up from $1.6 trillionin 2008. The banks size is partly the result of a perverseincentive: The larger and more systemically threatening theybecome, the more likely the government will be to bail them out inan emergency. That too-big-to-fail status gives them an advantagein the marketplace, allowing them to borrow more cheaply thansmaller, less dangerous banks. They commonly use thattaxpayer-subsidized money to make speculative bets, like the onethat went sour at JPMorgan. Opposition to this state of affairs has intensified recently, asprominent voices -- including Federal Reserve Bank of DallasPresident Richard Fisher, St. Louis Fed President James Bullard andformer Federal Deposit Insurance Corp. Chairman Sheila Bair -- havecalled for shrinking U.S. banks. Splitting the businesses oftraditional lending and risky trading into separate entities, theargument goes, would minimize the threat of another financialcrisis, protect taxpayers and bank customers, and better insulatethe U.S. economy against shocks. The debate over whether this wouldbe the right approach crosses partisan lines: Neither PresidentBarack Obama nor presumptive Republican nominee Mitt Romney, forexample, is in the break-up-the-banks camp. Market Roulette Undoubtedly, there is good reason to be worried about the dangersposed by superbanks that take depositor money with one hand whileplaying market roulette with the other. A big enough mistake on theroulette side -- where traders buy and sell securities such ascredit default swaps and collateralized debt obligations -- canimpair a bank s lending capacity or even cripple an entireinstitution. Despite the best efforts of the Dodd-Frank financial reformlegislation, it s still not hard to envision a situation where thegovernment would need to ride to the rescue of a JPMorgan, Bank ofAmerica Corp. or Wells Fargo (WFC) & Co. to prevent broadercontagion. The law requires more transparent trading ofderivatives, stepped-up oversight of systemically importantinstitutions and more capital to absorb losses. It gives regulatorsthe power to take apart a large, failing institution if it s athreat to the financial system, and creates significant hurdles forany future taxpayer bailout. In the yet- to-be-implemented Volckerrule, it seeks to forbid banks from speculating for profit withtheir own money. Nonetheless, credit-rating companies Standard& Poor s and Moody s Investors Service both say theyanticipate the U.S. government would rescue large banks in a futurecrisis, and the banks borrowing costs suggest the market agrees. It s tempting to consider a return to the days of theGlass-Steagall Act, when institutions engaged either in traditionalbanking -- taking customer deposits and lending -- or securitiestrading. Unfortunately, that s not likely to work. The financialsystem has evolved in some irreversible ways. It s increasinglyhard to differentiate between securities and loans, because thelatter are now often written as contracts that can be traded. Manyloan commitments must be considered derivatives for accountingreasons. Perhaps most important, the responsibility for making suchdifficult distinctions would fall to Washington, which has provedtime and again its inability to assess risk. As the experience ofLehman Brothers Holdings Inc. demonstrated, even a pure securitiesfirm can present a big threat to the system. Penalize Bigness A better approach would be to change the economic incentives. Makebigness more costly, rather than more rewarding. There are variousways to achieve this. Regulators can impose fees tied to the sizeof banks liabilities or to their reliance on fickle short-termfinancing, which tends to disappear in a crisis. Capitalrequirements for the largest banks can be raised far higher thanthe 7 percent the Fed currently requires. Research by economists atthe Bank of England suggests 20 percent would be the optimal levelfor economic growth. Beyond that, regulators can require bankholding companies to capitalize their lending and tradingoperations separately, so that losses in one business won t affectthe other; this ring-fencing approach is already being put inplace in the U.K. Don t count on the banks to be happy with increased capitalrequirements and risk-based fees. JPMorgan Chief Executive OfficerJamie Dimon, for instance, has argued that such requirements willcrimp lending and harm the broader economy. We ve debunked thatfallacy before. Bank executives real concern is that they willlose a taxpayer subsidy that has made it easy to boost theirprofits and bonuses in good times. U.S. taxpayers should never again have to worry that a bank smissteps will threaten economic disaster and necessitate a bailout.Giving banks an incentive to shrink will go a long way towardprotecting the financial system and making too big to fail a thingof the past. 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