April 15 (Bloomberg) — The six very large U.S. bank holding companies — JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley — share a pressing intellectual problem: They need to explain why they should be allowed to continue with their dangerous business model.

So far their justifications have been weak, and the latest analysis on this topic from Goldman Sachs may even help make the case for breaking up the financial institutions and making them safer.

Legislative proposals from two senators, Democrat Sherrod Brown of Ohio and Republican David Vitter of Louisiana, have grabbed attention and could move the consensus against the modern megabanks. Under intense pressure from Democratic senator Elizabeth Warren of Massachusetts, Federal Reserve Chairman Ben S. Bernanke conceded recently that the U.S. still has a problem with financial institutions that are seen as too big to fail. Pressed by Republican senator Chuck Grassley of Iowa, among others, Attorney General Eric Holder is sticking to his story that these companies are too big to prosecute. Cyprus offers another vivid reminder of what happens when banks become too big to save.

In this context, it is no surprise to see the financial sector wheel out its own intellectual big guns. A frisson no doubt rippled through the financial-lobbying community last week with the release of a report (PDF) from Goldman Sachs’ equity research team, “Brown-Vitter bill: The impact of potential new capital rules.” This is the A-team at bat, presumably with clearance from the highest levels of management.

Yet instead of providing any kind of rebuttal to the proposals in Brown-Vitter, the report may strengthen the case for breaking up the six megabanks, while also requiring that they and any successors protect themselves with more equity relative to levels of debt. Read the report with five main points in mind.

First, notice the lack of sophistication about bank capital itself. The authors write of banks being required to “hold” capital, as if it were on the asset side of the balance sheet. They go on to construct a mechanistic link that implies that “holding” capital prevents lending.

Banks don’t hold capital. The proposals are concerned with the liability side of the balance sheet — specifically, the extent to which banks fund themselves with debt relative to equity (a synonym for capital in this context). Higher capital requirements push companies to increase their relative reliance on equity funding, thus increasing their ability to absorb losses without becoming distressed or failing. If the transition is properly handled, there is no reason that more equity funding would translate into lower lending.

Second, the Goldman Sachs analysts seem completely unaware of the recent book by Anat Admati and Martin Hellwig, The Bankers’ New Clothes, in which those authors — who are top finance professors — debunk the way many bank representatives (including the authors of the Goldman Sachs note) look at issues around capital.

More equity relative to debt on a bank’s balance sheet means that equity and debt become safer: The bigger buffer against losses helps both.

Goldman Sachs makes much of the implications for return on equity, without mentioning any adjustment for risk. Bankers are generally paid based on return on equity without proper risk adjustment. Naturally, they like a great deal of leverage, but the reasoning they use to justify this is fallacious (see Chapter 8 in Admati and Hellwig).

Admati and Hellwig make the broader case that we can run our system much more safely. Goldman Sachs made a big mistake by refusing to take them on directly.

The bank is correct in its assessment that bank equity is higher than it was before the 2007-08 crisis, but this is the natural reaction to a near-death experience. Over the cycle, big banks will again become more leveraged (meaning they will have less equity relative to debt). As a result, Goldman is far too optimistic in its projection of the capital levels that will be needed when the next crisis hits. Current — and likely future – – levels of equity capital are insufficient for our intensely interconnected financial system.

Contrast Goldman Sachs’ note with this excellent speech last week by Tom Hoenig, vice chairman at the Federal Deposit Insurance Corp., on the illusion of the Basel III rules in particular and the right way to think about capital more generally.

Third, while the Goldman Sachs analysts get some points for stating the obvious about Brown-Vitter — “In our view such a bill would incent the largest banks to break up” — they fail to explain why this would be a bad thing.

They do, however, have a line about how banks could only be broken up along existing divisional lines, though they fail to make clear why they believe this is the case or how it would be the best deal for shareholders. Also, once the too-big-to-fail subsidies fade, these new companies would probably be smaller than projected by Goldman Sachs. Less complex, easier to govern and more transparent to supervisors sounds pretty attractive, to officials and investors. (Any client can request a copy of Goldman’s May 2010 report, “U.S. Banks: Regulation.” See Page 32, where it explains how JPMorgan and Bank of America would be worth more if broken up. Richard Ramsden is the lead author of both this report and the one cited above.)

Fourth, the analysts express concern that these smaller companies will be less diversified and therefore more fragile than the megabanks. Delusions of diversification are precisely what brought us to the brink of catastrophe in September 2008. Have the smartest people on Wall Street really learned so little?

From a social perspective, we want a system in which some companies can fail while others prosper, more like the conditions under which hedge funds operate. For macroeconomic purposes, we want diversity within the financial sector, not diversification within Citigroup (which has come close to failing three times since 1982 precisely because of this misperception).

Fifth, on supposed progress to eliminate too big to fail, Goldman’s arguments fall under the heading of what Winston Churchill called terminological inexactitude. The Orderly Liquidation Authority under the Dodd-Frank financial reform law won’t work for complex cross-border banks, such as Goldman, because there is no cross-border resolution authority. Living wills have so far proved to be a joke, and annual stress tests show every sign of becoming a meaningless ritual that undermines serious supervision.

What will move forward the debate? Will it be another money-laundering scandal, another disaster in the European financial system, or further revelations about the London Whale and Libor?

Or will it be thoughtful people sitting down to evaluate the best in-depth arguments for both sides? If it’s Admati and Hellwig v. Goldman Sachs in the court of informed public opinion, reformers win in a landslide.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You. The opinions expressed are his own.)

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