Big U.S. banks are making profits again primarily because the Federal Reserve subsidizes them. It lends the banks money at very low federal funds rates. The banks then lend that money to others, or use it to write off some of their bad loans or buy other assets.

In July 2007, the prime bank rate stood at 8.25% and the federal funds rate was 5.26%. On Dec. 24, 2009, the prime bank rate was 3.25%, but the federal funds rate was only 0.11%.

To put that into perspective, the federal funds rate fell 98% from July 2007 to Dec. 24, 2009, but the prime bank rate fell only 36%. The resulting subsidy is clearly helping banks make profits.

But big U.S. banks are not doing much real estate lending. Instead many are paying themselves high salaries and bonuses on the theory that such benefits are necessary to remain competitive.

Yet a huge need for additional lending to owners of commercial real estate is sure to arise this year and extend through 2013 as loans made from 2000 to 2006 come due.

Banks will demand much greater equity payments to make up for fallen commercial property values and lower loan-to-value ratios. So far, there is no evidence of their willingness to provide additional credit, other than to extend existing loans.

Slippery slope of bailouts

The former investment banks that have morphed into commercial banks are back to taking big risks. The same holds true for a few remaining big commercial banks.

These banks are now getting big subsidies from the Fed, and they believe they will be bailed out if another crunch occurs. They will inevitably go too far in pursuing high-paying risks. It is their nature.

A major banking executive in the United Kingdom thinks big banks cannot be constrained from excessive risks as long as they believe they are “too big to fail.”

That moral hazard will inevitably motivate selfish bankers to take excessive risks for their own profits, increasing the danger of another financial crisis.

But the British government has rejected this policy. Britain's leaders fear losing too much financial business to other banking centers that have not broken up their biggest banks.

I believe that the biggest American banks should be broken up. They hold too high a share of all U.S. banking assets and are too difficult to manage efficiently. As a result, taxpayers get stuck with bailing them out whenever a financial crisis occurs.

Taxpayers should aid only those institutions that engage in traditional banking. I'm referring to banks that reroute savings to borrowers who need money but are not terribly risky, and banks that avoid high-risk investments in derivatives and securities.

In November 2009, all 8,195 financial institutions insured by the Federal Deposit Insurance Corp. (FDIC) held a total of $13.3 trillion in assets. The 10 largest U.S. banks held 80.7% of all those assets. The four largest banks held 55.7%, and the eight largest held 75%.

Thus the remaining 8,185 FDIC-insured institutions — 99.9% of the total — held only 19.3% of all the assets in this system. There is no good reason for such an intensive concentration in our financial system.

Challenging the critics

Conservatives complain that the federal government is spending too much money and should cut back because of huge deficits. But the drop in consumption and asset values in the crash of 2008-2009 created both rising unemployment and falling gross domestic product (GDP).

If the government had not stepped in with federal spending to offset falling private consumption and investment spending, and to rescue the banking system, the economy might have collapsed.

According to Goldman Sachs, from the start of 2008 through the spring of 2009, the recession knocked $30 trillion off the value of global stock shares and $11 trillion off the value of homes worldwide.

These losses had a huge negative effect on U.S. consumer spending, business investment, and investments in securities and stocks.

From the fourth quarter of 2007 until the second quarter of 2009, U.S. consumption per year in 2005 dollars fell by $174 billion and GDP per year fell by $490 billion. Something had to make up for those losses in activity in order to prevent even greater declines in economic activity.

The savings rate among American households recently has fluctuated between 4% and 5% of disposable consumer income, compared with 1.7% in 2007.

In the first three quarters of 2009, personal savings in 2005 dollars averaged an annual rate of about $500 billion compared with $178 billion for all of 2007.

Those savings figures indicate a fall of $322 billion in consumer spending. The Economist magazine estimates that American spending is now $760 billion short of what would be necessary to restore full employment.

It would have been irresponsible for the federal government not to respond to the huge losses in both purchasing power and willingness to spend by advancing some government spending measures to keep the economy going.

Those measures included aid to banks, TARP, and the stimulus package, plus aid to the auto industry and subsidies for buying cars and homes.

True, federal policies themselves contributed to the credit crisis by deregulating the financial system, ignoring frauds in subprime lending, and keeping interest rates low (though the flood of financial capital into real estate was the real cause of low lending rates).

But those errors would have been greatly compounded by ignoring the need to offset a collapse in private spending and lending by increasing federal outlays.

Those who criticize the government for such spending almost never propose some other set of actions that would equally have prevented an economic collapse without more government spending.

In extraordinarily difficult times like these, it is necessary to adopt rigorous and unpopular measures to reduce the chance that similar disasters will recur in the future. In my opinion, breaking up our biggest banks is one of those difficult measures we ought to carry out.

ASSET SHARE OF 10 LARGEST U.S. BANKS

At the end of the third quarter of 2009, the 10 largest U.S. banks held 80.7% of all assets at FDIC-insured institutions. Of those funds, the four largest lending institutions held 55.7%.

Financial Institution Total assets as of Oct. 30, 2009 Percentage of all FDIC-Insured Institutions
Bank of America $2.2 trillion 16.9%
J.P. Morgan Chase $2.0 trillion 15.3%
Citigroup $1.9 trillion 14.2%
Wells Fargo $1.2 trillion 9.2%
Goldman Sachs $882.6 billion 6.6%
Morgan Stanley $769.5 billion 5.8%
MetLife Inc. $535.2 billion 4.0%
HSBC Holdings $390.7 billion 2.9%
Barclays Group $377.9 billion 2.84%
Taunus Corp. $368.2 billion 2.77%

Source: Federal Financial Institutions Examination Council

Tony Downs is a senior fellow at the Brookings Institution in Washington, D.C. Contact him at tonydowns3254@gmail.com.