By Tony Fratto, (202) 822-1205, tfratto@hamiltonps.com

After a year of occupiers bemoaning big bank profits, now the calls are to break up banks to “unlock value” for investors – the 1%! That’s some transformation!

The theory goes that large banks are somehow holding back smaller, but more valuable businesses and that government caps on bank size will help to unleash profits in these firms. Investors should therefore join with regulators in calling for breaking up the big banks.

The otherwise brilliant Sebastian Mallaby argued this case in his recent Financial Times column [“Breaking Up Banks Will Win Investory Approval”], arguing that the combination of big banks’ funding advantages in the debt market and funding disadvantages in the equity market suggest that the “capital adequacy police” should capitulate to (presumed) investors’ sentiment and just break up the banks.

Now, let’s set aside the reality that advocating a policy with the express rationale of elevating profits for bank investors would, on its own, drop jaws. Anything’s game if wrapped in populist bank bust-up goals. Let’s instead analyze the fundamental assertions.

“Investors” – market participants – are neither monolithic nor prescriptive in policy. Decisions are made in the aggregate, reflected in equity (and debt) pricing. If investors are skeptical of large banks, and the “capital adequacy police” maintain their hold for clear capital requirements, then the market will reduce the size and makeup of banks if warranted without the heavy hand of government.

This pricing and scaling process, by the way, plays out in all industries. In some circumstances, investors want larger, diversified companies, while in others, the market wants smaller, more narrowly focused pure-plays. In a competitive market, there’s room for all kinds, with varying degrees of predictability, cyclicality, risk and price premia. The short-term burst of spinning off the most profitable parts of a business (as Mallaby implies) does not always make the best long-term strategy. The market has the mechanisms to decide.

Bond market advantage?

Advocates for breaking up the banks often cite that big banks can more cheaply finance themselves in bond markets than small banks. Specifically, Mallaby offers two reasons:

First, U.S. tax policy subsidizes debt issuance relative to equity.

Second, market participants believe banks will be bailed out – and that therefore, bondholders feel safe, requiring less of a return for their investment.

The first point is entirely valid. Government policy does in fact subsidize debt over equity for banks… as well as for every other company in the country. It’s a tax distortion that should be fixed, but it’s not a unique benefit to banks.

The second point may be valid as well, but there’s absolutely no basis for such a belief. Unlike the actions taken during the financial crisis when bondholders were bailed out (however necessary at the time), the new Resolution Authority makes it clear that bondholders and other creditors will take losses if a firm fails. Recent ratings downgrades on the big banks from the major credit ratings agencies have underscored this market reality.

In the absence of a clear bond market advantage, let’s move on to equity, which has become more expensive for big banks.

Equity valuations

There are many variables affecting the profitability of banks and bank share prices, and these variables make pricing bank stocks difficult in the short-term.

Big banks face a slew of regulatory challenges and changes impacting profitability – the hundreds of Dodd-Frank reforms – including the Volcker Rule prohibitions, Durbin Amendment interchange fee price fixing, new FDIC insurance premiums for non-deposit liabilities, and significantly higher capital requirements for systemically important financial institutions are but a few examples. In recent years a significant amount of bank capital has also been tied up in provisioning for housing related losses.

Bank valuations may also be depressed due to the dilution of shareholders – as banks raise Tier-1 equity and, in some cases, have been blocked by governments from buying shares back or paying dividends. Government policy seeking to minimize trading and new counterparty risk regulations are probably impacting profitability as well.

All of these variables are real and observable, impacting top and bottom lines of the bank business, while the bank break-up value theory rests instead on ephemeral “moral hazard” pricing.

Mallaby rightly argues that equity investors are wary of being wiped out in the event of a bank failure. After all, Dodd-Frank Resolution Authority gives the FDIC the tools to wind down a large institution, wipe out its creditors, sell assets, and, if there is enough money left over after Treasury is repaid, to trickle down to bondholders. In Mallaby’s presentation, the “regulator’s selective concern with moral hazard” is driving up the cost of equity.

But there’s nothing “selective” about it. What Mallaby describes is the basic capital structure of any publicly traded company and normal resolution through bankruptcy. In bankruptcy, bondholders are senior to equity shareholders. Shareholders benefit from upside risk, but sit in a first-loss position if a firm fails. This is no different than in any bankruptcy: shareholders are in the exact position of, say Starbucks’ shareholders in the event of a bankruptcy.

Market-determined bank size

More to the point with these “investor value” theories, the market has all the tools it needs to reduce bank size if warranted. Even if it were appropriate, the market hardly needs government to “help” investors. Market participants are free to take their investments to smaller banks.

Meanwhile, regulatory requirements under Basel III require big banks to raise equity to buffer against potential future losses. This leaves banks with two choices: face higher costs for equity, or reduce assets – get smaller.

This is the market working. The outcome Mallaby seeks doesn’t require the heavy hand of government, just the enforcement of capital requirements. Currently, America’s four biggest banks have raised their common equity to assets (not risk-weighted, no games) ratio significantly since the crisis (Exhibit 1).

Indeed, from the strategic point of view of management, there are compelling arguments to being large, global and diversified in some cases, and compelling arguments to being small, local and more narrowly focused in others. In the long-term, business diversification spreads risk, lowers volatility and lowers the effects of cyclicality. There also exist economies of scale that size and diversification can generate.

To maximize shareholder value, some banks may decide to get smaller, while others may view the economies of scale and diversification of a global universal bank as vital to their success and responsive to their customers. Either way, investors are free to choose.

But there’s no useful principle where government should favor short-term profits for some equity investors while ignoring the needs of individuals and companies who rely on big banks’ scale, reach and expertise to operate in rapidly growing global markets (See my most recent piece on the growth of global financial needs here).

Banks can compete and serve customers at the global level while maintaining adequate capital, liquidity and transparency. And leave bank size to the market and the needs of customers.

Tony Fratto is a Managing Partner at Hamilton Place Strategies, former Assistant Secretary at the U.S. Treasury Department, and a former White House official. He is also an on-air contributor for CNBC.