The future of the financial industry sounded more like its past when CNBC aired an interview with former Citigroup chairman Sanford “Sandy” Weill last month. What surprised CNBC viewers was a seeming about-face by Weill, the architect behind the 1998 merger of Citigroup and Travelers Group, which at the time owned investment firm Salomon Smith Barney. The merger violated — and ultimately helped lead to the repeal of — the Glass-Steagall Act, a law dating back to the Great Depression that enforced a strict separation between banks that take deposits and those that invest in capital markets.

Let deposit-taking institutions stick to the roles they had during the days of Glass-Steagall, Weill argued. “Have banks [act as] deposit takers; have banks make loans and real estate loans. Have banks do something that’s not going to risk taxpayer dollars, that’s not going to be too big to fail.” He granted commercial banks the right to hedge investment risk so long as marking assets to market value restrains risks from going too far.

Weill also proposed a second tier of financial institutions that encourage risk and brace for consequences. “Let’s have a creative banking system, like we always had, where the financial industry can again attract the best and the brightest young people like they do in Silicon Valley, so that we can lead innovation that is necessary and [encourage] the entrepreneurship that’s necessary. We can’t have a world where it is impossible to make a mistake.”

Whether expressed as a sincere mea culpa or a disingenuous effort to launch himself back into the spotlight, Weill’s comments conceded that the great experiment behind institutions that were deemed “too big to fail” had itself failed. Deposit taking, securities brokerage, investment banking and insurance underwriting may not belong under one roof.

According to many analysts, Weill’s comments signal a much larger shift. “There is a growing chorus of voices from the financial sector that is calling for the breakup of the big banks, so his voice does not stand alone,” says Phil Angelides, former chairman of the congressionally appointed Financial Crisis Inquiry Commission. “It’s no longer a small movement.” The list includes at least three former CEOs of top banks or brokerages, Republican and Democratic Congressmen who voted to break up Glass-Steagall, several heads or governors, past and present, of regional Federal Reserve Banks, a former chair and a current board member of the FDIC, a former chief economist for the International Monetary Fund, a Republican presidential candidate and the governor of the Bank of England.

Angelides notes that when the Commission completed its work in January 2011, he still believed that large financial institutions could be regulated, given sound management and the right restrictions. His opinion has changed in light of further upheavals — not least the recent LIBOR scandal — that show how giant banks bend, or break, rules with impunity, even under intense regulatory scrutiny. “I have come to the conclusion that they are too big to fail, too big to manage and too risky,” Angelides says. “They can badly distort markets and democracy.”

Not So Fast

The financial crisis, which is still evolving, squelched any breathless expectations that accompanied the abolishment of Glass-Steagall and the passage of the Financial Services Modernization Act in 1999, which opened the floodgates for the reintegration of investment banking and commercial banking in the U.S. “We are here today to repeal Glass-Steagall because we have learned that government is not the answer,” former Texas Senator Phil Gramm, a co-sponsor of the Financial Services Modernization Act, said at the time. “We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom.” (Gramm soon demonstrated his own faith in competition by leaving the Senate to join a global financial services institution as vice chairman.)

Along with those who are now calling for a separation of investment banking and commercial banking, Wharton management professor Mauro Guillén says he is wary of the self-serving motive to build larger, systemically important financial institutions. As financial institutions become huge, they bestow disproportionate prestige and compensation on top managers — not to mention disproportionate financial risk on depositors, investors and taxpayers.

However, Guillén also cautions against dismantling large institutions too hastily. They can work in jurisdictions subject to a single regulator — as opposed to in the U.S., where competition among state and federal agencies to exercise control has propelled a regulatory race to the bottom. After lawmakers modernized banking in 1999, they failed to modernize regulation, Guillén points out. Despite accelerating mergers and consolidation in the financial industry, regulation remained fractured. “Three to four years later, there was so much confusion that banks asked who is supposed to regulate us,” he says. “The answer was, they could choose.” Risk migrated to the place where government was least equipped to deal with it — a precept often called “Stanton’s Law.”

If you want systemically important financial institutions, Guillén argues, then you must anoint a single supervisory authority with overarching power. Universal banks can operate successfully across various financial services, he says, if one powerful regulator has the final say on what institutions can and cannot do. That message is not yet clear to enough U.S. lawmakers. “When a bank is in 10 kinds of financial services, it does not need more regulation; it needs one regulator.” The Dodd–Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama in 2010, “hands more powers to the Fed, the Treasury and other agencies with authority over systemically important financial institutions. But owing to political pushback, none have full powers.”

Look at Canada, says Guillén, where five very large universal banks escaped the worst ravages of the financial crisis. He credits the stature of a single regulator in that country — the superintendent of financial institutions — who can force banks to comply with one consistent set of rules. “That authority is absent in the U.S.,” Guillén says. So long as it is, the financial system remains vulnerable to systemic shock.

Blame for problems facing gigantic financial institutions rests on sheer size and complexity more than on the union of commercial and investment banking, says Wharton finance professor Richard Herring. “We have permitted banks, investment banks and some insurance companies to achieve their size largely through regulatory-approved — and in some cases, regulatory-subsidized — mergers. None of these mega-institutions has gotten to this stage through organic growth.” In the process, they have had to transform patchworks of cultures, services, motives and regulatory requirements into seamless financial institutions, a task that may take years in the best of circumstances.

More Than One Way to Go Broke

Herring disputes what he calls “a nostalgic view” that permitting commercial banks to have investment banking powers was the underlying cause of the recent crisis that rocked the financial system. Banks can go broke the old fashioned way, he says, by making bad loans. Under the weight of disastrous commercial real estate loans, Citibank was essentially bankrupt in 1991 — long before it owned an investment bank. Credit risk took a somewhat different form this time, chiefly as subprime loans to homeowners, but, says Herring, it was essentially the same problem. Excessive concentrations of credit risk were not appropriately monitored, managed or understood.

What’s more, pure investment banks may pose systemic risks even without deposits. “None of the big five investment banks that we lost had a significant deposit base,” says Herring. The one judged to lack systemic relevance, Lehman Brothers, provoked instantaneous global chaos after regulators let it fail. Size certainly matters, he adds, but not so much as centrality to the functioning of capital markets and inter-connectedness. That insight was implicit in the government’s decision to rescue AIG, despite the fact that it held only negligible deposits.

“It is true that genuine economies of scale and scope exist,” Herring notes, “largely based on the enormous fixed cost of information technology and, to a much lesser extent, maintaining a strong brand image.” However, any blueprint for the financial industry must weigh potential gains that economies of scale garner against potential costs. Herring cites the challenge of supervising or managing huge, complex institutions and the impact on society of inadequate management. Diseconomies of scale include disproportionate increases in administrative overhead, agency problems in compensation systems and sheer administrative complexity. Large institutions are inherently bureaucratic and less agile than smaller counterparts. Diseconomies of scope, he notes, include the temptation to cross-subsidize products or services by use of an internal capital market that is less efficient than external markets, greater opacity to investors, and the costs of reassuring customers that conflicts of interests will be managed effectively.

So long as size and complexity persist, we cannot claim that we’ve solved the too-big-to-fail problem, according to Herring. Yet there may be no way to unravel these institutions without harmful disruption, he says. “Many of these institutions have several thousand subsidiaries in scores of countries. It is inconceivable that they could be taken through an orderly bankruptcy procedure.” In 1998, the top five financial institutions in the U.S. controlled 8% of banking assets; now they control 16%. “This should not have been permitted.” 

Given such dramatic concentration, the genie is out of the bottle. In that case, Herring asks, what’s to be done? The most useful tool so far is the government’s requirement that each systemically important financial institution develop a rapid resolution plan for dismantling in an orderly fashion under stress. A first round of plans was submitted in July. “We have some indications that the very process of drawing up such plans has caused some institutions to clean up their excessively complex structures,” Herring says. “What happens in response to this round will be critical,” he adds. “Will the regulators have the political backing and courage to demand that excessively large and complex financial institutions simplify and adjust their size to manageable dimensions?”

Meanwhile, particular events and trends are still imperiling the banking system, Guillén warns in a recent article titled, “The Banks’ Lost Credibility,” published in the Korea Times. Specifically, he cites the manipulation of LIBOR, money laundering and banks recording continuing losses from ill-conceived investment. “Each of these undermines confidence in banks, multiplies the calls for more regulation, and makes the general public skeptical and suspicious about banks, bankers and their motives,” Guillén writes. “Untrustworthy banks are the last thing that’s needed if we are to overcome this crisis.”