Banks Need to Dump Brokers: FDIC Director

Allowing banks to engage in formerly restricted activities gave the largest banks "cost advantages related to the safety-net," which "encouraged and facilitated consolidation among market players resulting in the 10 largest financial firms increasing their control of industry assets from 31 percent to 68 percent," Hoenig said, adding that "we acknowledged all too late that the failure of any one of these firms would have a severe systemic impact on the broader economy."

The FDI Director also said that broadening the banks' safety net "fundamentally changed" the industry's business model: "In commercial banking the model is set around win-win, where the success of the borrower means success to the lender in the repayment and growth of the credit relationship. In broker-dealer and trading activities, the incentives are centered around win-lose in which the parties are placing bets on asset price movements or directional changes in activity."

Having the broker-deal business "within the safety-net changes the risk/return trade-off, changes behavior, and adds significant new risks to commercial banking and vulnerability to the safety-net," Hoenig said.

Not only have the largest U.S. banks greatly expanded their brokerage activities over the past two decades, the largest investment banks chose to become regulated as traditional bank holding companies, coming under Federal Reserve supervision.

While Hoenig's proposal would appear to have a very small chance of becoming law in the current political environment, we are heading into an election, and as we saw with Dodd-Frank, the ongoing credit crisis and anti-Wall Street fervor can lead to major regulatory changes. While most of Dodd-Frank hasn't yet been implemented, the banking landscape has changed in a major way, with the creation of the Consumer Financial Protection Bureau, the proposed adoption of Basel III capital requirements and the Volcker Rule being just a few examples.