Why Not Break Up Citigroup?

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

Earlier this week, Richard Fisher, the president of the Federal Reserve Bank of Dallas, captured the growing political mood with regard to very large banks, observing, “I believe that too-big-to-fail banks are too dangerous to permit.”

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Market forces don’t work with the biggest banks at their current sizes, because they have great political power and receive almost unlimited, implicit subsidies in the form of protection against downside risks — particularly in times like these, with Europe’s financial situation looking precarious. Mr. Fisher added:

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Downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Then, creative destruction can work its wonders in the financial sector, just as it does elsewhere in our economy.

Mr. Fisher is a senior public official and also someone with a great deal of experience in financial markets, including running his own funds-management company. I increasingly meet leading figures in the financial sector who share Mr. Fisher’s views, at least in private.

What, then, is the case in favor of keeping mega-banks at their current scale? Vague assertions are sometimes made, but there is very little hard evidence and often a lack of candor on that side of the argument.

So it is refreshing to see Vikram Pandit, the chief executive of Citigroup, go on the record with The Banker magazine to at least explain how his bank will generate shareholder value. (Viewing the interview requires registration, however.)

Citi is one of the world’s largest banks. According to The Banker’s database, which includes data from the end of 2010, it had total assets of just under $2 trillion — putting it in the top 10 worldwide. Over all, The Banker places it as No. 4 in its “Top 1,000 World Ranking.” Citi is No. 39 on the Forbes list of the top 500 global companies, with total employment of 260,000.

Is there indication in Mr. Pandit’s vision that mega-banking will be good for the rest of us in the future? Don’t look for Citi to drive any kind of rethinking of the consumer market in the United States; Mr. Pandit just wants to downsize that part of his business.

The engines of growth, Mr. Pandit said, will be “the global transactions services business” and “emerging markets.”

Transaction services are important, but they do not require a very large balance sheet; these can equally well be performed by a network of small, nimble financial firms. Global commerce existed for centuries before banks built up risks that are large relative to their home economies.

And emerging markets are risky. Mr. Pandit is essentially betting that Citi can ride the cycle in those countries. Probably there will be relatively good profits for a number of years, and this will justify high compensation levels. But when the cycle turns against emerging markets, as it did in 1982, what happens?

In 1982, Citi had a large loan exposure in the emerging markets of the day — Latin America, and the Communist nations of Poland and Romania — and it was saved from insolvency by “regulatory forbearance,” meaning that the Federal Reserve and other regulators did not force it to recognize its losses. Citi was a relatively big bank at that time, but much smaller than it is today.

And its complex global operations are exactly what would make it very hard to put through orderly liquidation under Dodd-Frank. I argued here in March that there is no meaningful resolution authority for global banks; before and after that post I’ve taken this point up in private with senior officials in the United States and Europe responsible for handling the potential failure of such entities.

No one disagrees with my main point: we cannot handle the collapse of a bank like Citigroup in “orderly” fashion.

Jon Huntsman put mega-banks on the agenda for the Republican primaries, with a blistering commentary in The Wall Street Journal a few weeks ago: “Too Big to Fail Is Simply Too Big.”

Other contenders for the Republican nomination have followed his lead, including most recently Newt Gingrich. Whoever ends up going head to head with Mitt Romney is likely to make good use of this very theme — because Mr. Romney already has so much financial support from the top of Wall Street, it will be very hard for him to respond effectively.

Breaking up the biggest banks is not a fringe idea to be brushed off. Mr. Fisher is speaking for many people who work in financial services, who agree that the big banks are not good for the rest of us. Mr. Pandit’s interview just reinforces this point.

Any Republican candidates who say they are fiscally responsible must eventually confront this issue: What was the role of big banks in the enormous recession and consequent vast loss of tax revenue since 2008? Which sector poses clear and immediate danger to our fiscal accounts, looking forward — and in a way that is not yet scored properly in any budget assessment? As Mr. Fisher put it, rather graphically,

Perhaps the financial equivalent of irreversible lap-band or gastric bypass surgery is the only way to treat the pathology of financial obesity, contain the relentless expansion of these banks and downsize them to manageable proportions.

I suggest that Mr. Fisher could reasonably begin with Citigroup.