Calls by former Citigroup Inc. Chief Executive Officer Sanford Weill and others to break up the big banks reflect lingering public fear and anger toward financial institutions that seem too big to fail.

These calls, however, ignore the unintended consequences of making our global banks too small to succeed: Much of the business will migrate to non-U.S. banks and the less-regulated shadow banking sector. Weill and the rest also neglect to consider key reforms that protect taxpayers from a potential failure.

In a global economy, there is a need for financial institutions with scale and global capacity. Large banks offer their customers products, services and infrastructure that smaller banks cannot match, from multicity branch networks to global coverage that lowers costs. Philadelphia-based chemical company FMC Corp., for example, relies on large banks to fund its $1.5 billion revolving credit line and to offer worldwide support for its financing needs.

The global transaction services that big banks provide to governments, multinational corporations and institutions simply couldn’t be replicated as efficiently or as cheaply by smaller banks, or even a patchwork of smaller ones. As JPMorgan Chase & Co. CEO Jamie Dimon recently pointed out, it takes a certain scale to offer a $5 billion credit line.

Progress Made

Too-big-to-fail is a serious issue, but there has been more progress on this front than is widely understood. The orderly liquidation authority in the 2010 Dodd-Frank financial-reform law means that large banks can and will be allowed to fail in the future. Dodd-Frank allows the Federal Deposit Insurance Corp. to keep a failing bank running, but shareholders will be wiped out and bondholders, not taxpayers, will cover any government losses.

The law prohibits bondholders from receiving a taxpayer bailout and instead requires them to take “haircuts.” This means that investors thinking of providing funding to a risky bank know in advance that they will take losses if things go bad. This reverses the previous advantage of large banks in obtaining low-cost funding from investors who expected to be made whole from a government bailout.

Orderly liquidation authority isn’t perfect. There will still be government intervention in financial markets, and Dodd-Frank formalizes that. But the intervention will impose costs on bank investors, which in turn will reduce large banks’ funding advantage. Some argue that this broad power is insufficient, and that banks over a certain size should be told to shrink or be forcibly broken up. This argument is based on faulty analysis.

First, it overstates the danger that big banks pose to the U.S. economy post-Dodd-Frank. Unlike in other regions, the U.S. financial system is small relative to the economy it supports, after adjusting for different accounting standards. According to the Federal Reserve, the assets of the top five U.S. banks equal 56 percent of gross domestic product. The five largest German banks have assets that total 116 percent of GDP and in the U.K., the top five are at 309 percent of GDP, according to their central banks.

In addition, growth in the formal banking sector over the past 20 years has lagged behind the increase in U.S. exports and the gain in the Standard & Poor’s 500 stock index over the same period. There is arguably less capital in the banking sector than needed to support strong U.S. growth.

Second, the break-up-the-banks argument underestimates the negative consequences of forced downsizing. Some services offered by big American lenders will migrate to regional and community banks and credit unions, which are vital participants in a well-diversified U.S. financial system. But large banks in other countries and lightly regulated firms in the shadow banking system will snatch up a great deal of the business.

Shadow Banks

Shadow banks are almost three times the size of the formal banking sector, and they are less transparent and less regulated, even with heightened attention from the newly created Financial Stability Oversight Council. Lending through shadow banking channels such as securitization or repurchase agreements might not be covered by a taxpayer guarantee, but failures in these parts of the financial system during the crisis brought about government intervention all the same.

One need only look at the situation with money-market mutual funds, where one fund’s failure during the crisis put the entire economy at risk and required the government to intervene. This part of the shadow banking system has fended off badly needed reform. Far from ending too-big-to-fail, breaking up the banks would merely push business into even larger overseas banks or to financial firms with less oversight.

Too-big-to-fail needed to be addressed. It was. Breaking up large banks imposes economic costs without corresponding benefits in terms of financial stability. It would be better to focus on making the overall system safer without handing an advantage to one part of the financial system over the other.

(Phillip Swagel, a professor at the University of Maryland’s School of Public Policy, was assistant secretary for economic policy at the Treasury Department from December 2006 to January 2009.)

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Today’s highlights: the editors on whether we’re better off than four years ago, on why Quebec’s separatism is a dead end and on the disasters that await the end of Europe’s summer torpor; Susan Antilla on checking if your broker is a crook; Caroline Baum on why Americans should like Mitt Romney; Margaret Carlson on the impossible politics of abortion; Jonathan Mahler on Stephen Strasburg’s false choice.

To contact the writer of this article: Phillip Swagel at pswagel@umd.edu.

To contact the editor responsible for this article: Paula Dwyer at pdwyer11@bloomberg.net.