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Is Fed Signaling Stance on Bank Break-Ups?

Friday, 15 Mar 2013 | 2:31 PM ET
Source: Federal Reserve | Flickr

Former Federal Reserve chairman Alan Greenspan believes the problem of "Too Big to Fail" has gotten worse since the financial crisis.

To fix it, Greenspan told CNBC's "Squawk Box" Friday, "if push comes to shove…I would be in favor breaking up the banks."

The comments revive a longtime debate over whether big banks created justifiable synergies or an inexorable web of risk—a debate for which some fresh fodder has also been provided by the Federal Reserve's stress tests, out Thursday.

In the Fed's calculus for determining whether a bank could make it through a Depression-like crisis includes forecasts that U.S. gross domestic product, the stock market and housing prices all fall sharply. However, the six big banks get an additional test: A "separate global market shock" for "large trading, private equity and counter-party exposures from derivatives and financing transactions."

(Read More: Fed Okays Plans at 14 Big Banks)

In other words, investment banks get forced through another gauntlet of stress.

Greenspan: 'Irrational Exuberance' Last Phrase I Would Use Right Now
The stock market is significantly undervalued by historical calculation, said Alan Greenspan, former chairman of the Federal Reserve. "The reason why the stock market has not been significantly higher is there are other factors compressing it lower. But irrational exuberance is the last term I would use to characterize what is going on at the moment."

On the other side, the pure-play investment banks appear much weaker than the universal banks, with Morgan Stanley and Goldman Sachs posting the lowest capital buffers of the group. JPMorgan, which boasts a formidable investment banking and trading operation, was just above.

(Read More: Bank's Stress Tests Explained)

Universal banks in which investment banking is a smaller portion of the overall revenues fared better, too. (Of course, regionals not subject to this additional microscope fared the best entirely.)

It would seem, then, that—at least by the Fed's opaque measure—standalone investment banks are viewed as inherently riskier.

Senior Fed officials said that perceived weakness in the investment banks, in large part, reflects the serious shortcomings of pre-crisis regulation. But the officials were mum on the idea that additional lines of business like mortgage banking and commercial lending provide a cushion for the riskier investment bank, a position long argued by bank executives.

Right now, Washington's verdict on breakups will likely remain amorphous until the Volcker Rule, a law set to define and limit certain trading practices by banks, comes into focus, these officials said. Under a final Volcker Rule, officials argued, the final, optimal levels of risk at investment banks will be settled.

In the meantime, one thing is clear: The Fed, altogether, is getting tougher—not only raising its standards for banks' capital positions each year, but expecting banks to follow suit with their internal models.

Just ask Ally Financial, the only bank holding company that failed to clear the Fed's hurdles multiple times.

(Read More: Ally Fails Fed Stress Test, Will It Ever Get Off the Dole?)

In a statement released by Thursday by Ally, formerly the financing vehicle of General Motors, the company vividly highlighted its frustration:

"…the loss rates assumed by the Fed for Ally's commercial and industrial loans, namely dealer floorplan lending, are more than seven times the losses experienced during the peak of the last recession and more than three times the assumptions used by the Federal Reserve in last year's [stress test]."

It seems the bar is rising.

By CNBC's Kayla Tausche; Follow her on Twitter: @KaylaTausche

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