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Asset Purchases Taper Is Least of Banks’ Worries

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Banks have been skipping along the yellow brick road, content in a fairytale landscape awash with quantitative easing. But the sky darkened last week, as the industry's best friend threatened to become foe. The Federal Reserve has been a reliable companion since the financial crisis, but Ben Bernanke's chatter about TOTO (the new acronym for the "timing of tapering off" of stimulus) holds deep implications.

As the Fed begins working on TOTO, it may also begin anew to deal with excessive risk taking and to ensure that banks lend money to the real economy instead of hoarding cash. One idea is to turn banking giants into munchkins – smaller banks.

James Bullard, president of the St Louis Federal Reserve, is concerned that banks are still too big to fail, even after Dodd-Frank reforms. "They implicitly have government support and that is leading them maybe to take extra risk. I've been pushing the debate that we should do something more on the US side to try to get these institutions smaller, so if they did screw up and they made a goofy trade we'd be able to say… you are going to go out of business and it's not going to bring down the US economy or the world economy," said Bullard on CNBC Europe's "Squawk Box".

(Read More: 'It's a Big Moment for Japan': Fed's Bullard)

Regulators in the City agree that banking reforms are unfinished. The JP Morgan whale trading debacle that cost the bank $6.2 billion served as a reminder that risks still loom large. Andy Haldane of the Bank of England described the sector last week as a long way short of normality. "Whether it's too big to fail, or too big to bail, or too big to jail, what the "whale" incident did signify is a real risk of too big to manage...too complex, too large, too interconnected, too interwoven for anyone, no matter how brilliant, to get their head and their arms around it," he said.

Bullard and Haldane seem to agree on a lot. Both dismissed the argument that big banks are necessary to sustain large corporates. Haldane admitted the first reaction is more red tape but warned more regulation isn't the prescription. "It is understandable if you're a regulator like me, you are facing this deeply complex system the instinctive reaction is to reach for a complex rule book but, if you think for a second, this is a deeply perverse response as you don't fight fire with fire and you don't fight complexity with complexity."

If regulators have their way, banking chiefs will be presiding over smaller empires, with fewer rules and trotting down the path of innovation. A fairytale ending eventually, but where does that leave banking profits and bank stocks? It could be another reason to look at TOTO and flee.

—By CNBC's Karen Tso. Follow her on Twitter @cnbckaren