Breaking up Chase: Good for shareholders and taxpayers by Sheila Bair @FortuneMagazine May 25, 2012, 9:44 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons FORTUNE – When I was a child, my sister and I loved watching the goings-on at a chicken farm near my grandmother’s house in rural Kansas. Chickens are interesting social animals, resembling, somewhat, the way we in Washington interact with one another. They were always on the lookout for one vulnerable bird that they would corner in the coop and then peck relentlessly on its head. Jamie Dimon, the CEO of J.P. Morgan Chase JPM , is getting his head pecked these days. To be sure, he set himself up for it by very publicly leading the industry chorus of criticism against key financial reforms. He has made many good decisions for his bank, but Chase’s recent serious missteps have provided reform advocates with loads of ammunition. I mean, really. Losing $2 billion (and counting) by “hedging” a bond portfolio against losses? What were he and his minions thinking? If Dimon wants to regain his place in the pecking order, he should take the initiative and shrink Chase to a manageable size. In the meantime, the market is punishing his bank even more severely than the Washington pundits are. Chase’s share price was down more than 20% in the week or so after it announced its trading loss on May 10. Chase’s defenders point out that a $2 billion loss is less than 1% of capital, and perhaps the market is overreacting, but let’s face it, no one really knows what is going on inside Chase any more than we understand the risks of the other megabanks. As I wrote in this column in January, banks of the size and complexity of J.P. Morgan Chase, Citi C , and Bank of America BAC are just too difficult to manage, even for talented managers like Dimon. Whatever economies the megabanks achieve from their size are more than offset by the challenges in managing trillion-dollar institutions that are into trading, market making, investment banking, derivatives, and insurance, in addition to the core business of taking deposits and making loans. This is one of the reasons why, even before the crisis, their shares performed more poorly than those of the well-managed regional banks, and continue to do so. More: J.P. Morgan Chase – No. 16 on the Fortune 500 Given the poor shareholder returns, why are these unstable behemoths allowed to exist? There is the perception that the government will not let them fail. Also, their size and complexity protect them from market pressure, and shareholder activists with a mind to break up the big banks are stymied by the megabanks’ complex web of thousands of legal entities. In Washington no one is seriously discussing breaking up the big banks. That said, the best chance of restraining these giants is the hugely important regulatory reform, now being implemented by the FDIC and the Fed, that forces the banks to produce “living wills.” These rules require that big banks map their business lines to their legal entities. So, for instance, Chase and others would have to identify the legal entities that support their investment-banking operations, their trading and brokerage activities, their commercial and retail lending, and so forth. The idea is to have a credible breakup plan in place if they get into trouble. Meaningful enforcement of this rule and public disclosure of the plans would help convince the market that too-big-to-fail is over. It would also help shareholders figure out how to start breaking up the Goliaths. Yet instead of waiting for the government or shareholders to act, the leadership of these megabanks should take the lead in downsizing. The best way for Dimon to provide a better return to his investors is to recognize that his bank is worth more in smaller, easier-to-manage pieces. Let’s face it, making a competitive return on equity is going to become even harder for megabanks as their capital requirements go up, their trading and derivatives activities are reined in, and their cost of borrowing rises as bond investors recognize that too-big-too-fail is over. If, by downsizing, Dimon can achieve valuations comparable to the regional banks’, he will potentially release tens of billions of value to his shareholders. And rule the roost once again. This story is from the June 11, 2012 issue of Fortune.