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(Repeating story sent earlier to additional subscribers)
By Olivia Oran and Anjuli Davies
NEW YORK/LONDON, Feb 19 (Reuters) - When the U.S. FederalReserve's newest policymaker Neel Kashkari dropped a bombshellwith a call to break up big banks on Tuesday, it was met with apredictably indignant response from their lobbyists. Onedescribed his comments as "blind."
But while no one in the executive suites of major globalbanks would want authorities to force them to split up ordownsize, many top bankers acknowledge that their institutionsmight be better off smaller and simpler. They just worry thatany major restructuring could go all wrong because of the waypost-financial crisis regulations are applied.
In interviews with Reuters, six senior bankers said they arestruggling with the costs and restrictions they face as a resultof new regulations, as well as a weak global economy andtroubled financial markets. The bankers, who are or recentlywere in positions ranging from business division head to CEO,spoke on the condition of anonymity so they could be candidwithout upsetting regulators or investors.
"Fundamentally, the business has to change," said oneveteran banker who was on the executive committee of a majorEuropean bank until recently. Big banks' shareholder returnshave sunk "too low," he said.
These problems are not new, but they have fresh relevance asDeutsche Bank AG confronts questions about itscapital adequacy, Barclays PLC faces pressure to breakup and CEOs of big U.S. banks struggle with a loss of investorconfidence in their stocks.
For a graphic of U.S. banks' price-to-book ratios, see http://reut.rs/1SG0NDL
Management teams in the U.S. and Europe are now taking ahard look at dramatic business model changes, but none of theoptions are particularly attractive, the bankers said.
Merging to cut costs and improve margins is out of thequestion, given the hurdles banks would likely face fromregulators who do not want "too-big-to-fail" institutionsgetting any bigger. Splitting apart is complicated by capitalrequirements that would make standalone trading businesseseconomically unfeasible - and by the fact that there are few, ifany, buyers for the assets banks want least.
Some top bankers say they are left with little choice but tomuddle through what they fear will be a long, dark period ofweak earnings, angry shareholders and gradual shrinkage.
The problem has gotten so bad that Deutsche Bank CEO JohnCryan recently said on a public conference call that he'd muchrather be CEO of a simpler, retail-focused bank like Wells Fargo& Co, which has only a modest investment bankingoperation.
"Unfortunately," he said, "there are lots of things I wishfor that are not going to come true."
RATCHETING UP CAPITAL
Kashkari's comments, in his first speech as head of theMinneapolis Fed, were surprising because he is a former GoldmanSachs banker, a Republican, and was a senior Treasury officialin President George W. Bush's administration during thefinancial crisis.
They partly echoed the stance of Bernie Sanders, who hasalso called for big bank breakups and criticized HillaryClinton, his rival in the struggle to be the Democraticpresidential candidate, for being too close to Wall Street. Someof those vying for the Republican nomination have alsocriticized regulations brought in after the crisis, saying theywould repeal the Dodd-Frank reform law.
In an interview with Reuters on Wednesday, Kashkaricriticized Dodd-Frank's so-called "living will" rule, whichrequires banks to show how they can be dismantled in an orderlyway if they fail, without creating risk to the broader financialsystem. Kashkari said he believes the rule would not work in acrisis scenario - that banks would simply be bailed out again.
"I challenge anybody who thinks, in a stressed time, wewould put these banks through resolution," he said. "I reallydon't think it will happen."
One way to force large financial firms to break up is to"aggressively ratchet up" their capital or leveragerequirements, Kashkari said. He warned, though, that banks wouldlikely fight hard against any such proposal.
Indeed, Tony Fratto, who worked with Kashkari at theTreasury Department and is now a bank lobbyist at Hamilton PlaceStrategies, said his former colleague's comments were out oftouch with reality.
"This is something like re-opening the barn door after thehorse is in the stable," Fratto said. "Love or hate Dodd-Frank,it's simply blind to say that it hasn't significantly improvedsafety and soundness."
OUT OF ARROWS
Securities analysts and consultants say that banks are in anunenviable position because moves they might have made in thepast to improve profitability have been hindered by regulation.As a result, they have struggled unsuccessfully for years to gettheir returns on equity above single digits.
"In some ways, banks have become bad utilities," said FredCannon, a bank stock analyst with KBW. "With utilities, you havestrict regulation in what you can do and charge, but in the endinvestors get a reasonable return. With banks, that last piecehasn't happened."
Bank executives have long argued that weak returns are a"cyclical" issue that should go away when markets begin toflourish again. But as the industry approaches the eighthanniversary of the financial crisis's nadir, questions aboutwhether they face a secular rather than a cyclical profitproblem have only grown louder. And top bankers are nowwondering how they can possibly grow revenue under a sprawlingset of global financial regulations that limit what they do, andsometimes conflict with one another.
For a graphic showing bank earnings and share priceperformance, see http://tmsnrt.rs/1mZb4h8
One common example raised is how new capital rules canpenalize banks for being big but also discourage them fromgetting smaller.
For instance, due to their size, the eight largest U.S.banks must collectively hold $200 billion in extra capital,which weighs on shareholder returns. Included in the capitalrequirement is a fixed amount each bank must hold to represent"operational risk."
Although the Fed does not explain exactly how it comes upwith that figure, it is not just a function of size: Bank ofAmerica Corp must hold 25 percent more operational riskcapital than JPMorgan Chase & Co, the biggest bank inthe country.
Bank of America has said it's taken steps to address theFed's concerns by cutting back on certain revenue-producingactivities that created operational risk. Nonetheless, the banksays it has so far been unable to persuade the Fed to reducethat capital requirement. Its shareholder returns suffer as aresult, because revenue is dropping faster than capital costs.
"Every bank is trying to figure out, with bigger capitalrequirements and profit pressure, how can they create acceptablereturns for their shareholders," said John Weisel, an Ernst &Young executive who advises global banks on business strategy.
After years of cost-cutting, he said, CEOs are askingthemselves: "We've used all the arrows in our quiver, so whatare we going to do next?"
BREAK-UP DEMANDS
European banks are behind their U.S. competitors inaddressing a more regulated environment and, in some cases, areflailing around for answers.
Last week, Deutsche Bank shares hit an all-time low onworries that it won't be able to buy back some bonds that canconvert into equity. Deutsche regained some value after itoutlined plans to repurchase $5.38 billion worth of other bonds,but investors' concerns don't seem to have been entirelyassuaged.
Meanwhile, Barclays has come under pressure after aBernstein analyst wrote an open letter on Feb. 5 imploring CEOJes Staley to break up the bank.
Rob McDonough, who advises financial institutions on riskmanagement at Angel Oak Consulting Group, says megabanks mayhave little choice but to get significantly smaller.
"It's too expensive," he said, "for banks to be big."
(Additional reporting by Pamela Barbaglia, Sinead Cruise, DanFreed and David Henry; Writing by Lauren Tara LaCapra; Editingby Carmel Crimmins and Martin Howell)
