Splitting big banks: Why J.P. Morgan should go first

July 26, 2012, 3:57 PM UTC

J.P. Morgan CEO Jamie Dimon

FORTUNE — J.P. Morgan should split in two, as former Citigroup chair Sandy Weill has recommended for all big banks. In fact, it should go first. But before it does, the bank’s board needs to address its own governance issues so the split goes well.

It has been another tumultuous couple of weeks for J.P. Morgan (JPM). Events continued to raise questions about the veracity of company statements and the propriety of its motives and actions. Last week, a FERC filing in an energy manipulation investigation provided a “detailed, email-by-email summary” to back up its assertions that “J.P. Morgan repeatedly and deliberately insisted that unprivileged emails were privileged.”

Bringing the investigation into sharper focus, the Financial Times recently reported that Wall Street banks like J.P. Morgan are becoming more heavily involved in the oil trading business and supplying oil to refiners.

CEO Jamie Dimon would not answer questions about Libor manipulation during the bank’s second quarter earnings call, but the Wall Street Journal has reported that its traders are now under investigation for conspiring to rig the rates.

MORE: 9 winning-est executives: Fortune’s picks

Last week, Senator Carl Levin along with commercial copper consumers spoke out in opposition to a J.P. Morgan and Blackrock (BLK) proposed copper exchange traded fund on worries it would raise copper prices.

While this just offers a flavor of recent concerns, it hardly represents the full story. New lawsuits and investigations are underway.

On July 13, two bank analysts suggested the bank was too big to manage. So will J.P. Morgan heed Weill’s recommendation or just put its head in the sand and hope it all goes away?

To save needless suffering, regulators need to speak out, the J.P. Morgan board should address its governance problems, and, as Weill recommends, the company should be split in two.

First step: Cleaning up J.P. Morgan’s board

A well run audit committee would never have allowed Jamie Dimon to be “dead wrong” about the importance of the trading losses on April 13. As we now know from the July 13 analyst meeting, while Dimon was saying the losses were insignificant in April, unbeknownst to the investing public, embedded in the April 13 numbers were $718 million in losses from the chief investment office (CIO). The board had received warnings about the CIO in prior years and had the benefit of news reports in early April.

A functional audit committee would have asked about the level of trading losses in the first quarter numbers. They would have had practices in place to review and approve earnings releases in advance and never would have allowed management to show the explanation on page 12 of the April 13 earnings presentation  without a trading loss disclosure. Alternatively, if the committee knew of the loss on April 13 and remained silent, this would be wrong as well. Either way, valuable assistance was kept from the CEO and CFO.

Then there are the other internal controls issues. Sufficient audit committee oversight could have prevented the company from misstating its risk levels and prevented restatement of its first quarter trading losses, which doubled to $1.4 billion.  J.P. Morgan has said its procedures in the CIO office were weaker than those in its investment bank; a standard internal audit review should have unearthed this.

MORE: Fantasy Executive League: Fan faves

Is the company just too big to oversee? Did the audit committee members put in the time and attention required to do their jobs well?  Are they truly independent-minded?

While some managers will have substantial clawbacks in the wake of the trading debacle, the compensation committee is punting on others. Having two sets of standards – one for top management and another for those down the line — sends the wrong message.

A well-run compensation committee would have implemented meaningful top management bonus deferral programs, as regulators have recommended. They would not rely on clawbacks — which, unlike bonus deferrals, occur after the fact. They would also not be using earnings or stock price metrics as implicit or explicit bases for rewards. Earnings, which are highly malleable at a financial services firm, and stock price, which represents feedback from shareholders on opaque financial statements, are hardly relevant measures.

Although J.P. Morgan’s Mike Cavanaugh brushed off one analyst’s question about the traders’ compensation on July 13, it’s really the board compensation committee that should be addressing what may have motivated traders to goose earnings and potentially hide losses. Until it implements bonus deferral mechanisms, the committee should not be waiting for the end of 2012 to claw back pay from the CEO and CFO given the material weaknesses in financial reporting and the number of issues arising on their watch. And the committee should be reviewing whether internal audit failed to meet its responsibilities and whether pay should be clawed back there as well.

The nomination and governance committee should be looking at whether the board has the right people in place to meet the tremendous operational and litigation challenges at the company. And it should be moving swiftly to re-write the board’s mandate to take full charge of CEO succession.

Next up: Split the behemoth

After taking a hard look in the mirror and cleaning its own house, the J.P. Morgan board should begin a process to split the bank in two. News Corp is taking a similar action in the wake of its scandals and it makes sense.

The bank is too big to manage, as analysts pointed out.

Lucky for J.P. Morgan it already has two names it can use: J.P. Morgan for the investment bank and Chase for the commercial bank franchises.

At J.P. Morgan, such a split would not result in a weak business-strong business scenario. Both sides have their strengths and their challenges. The split would allow the board to consider more fully how to reconstitute itself and identify successors who would best be able to run the two separate entities.

MORE: Hostess is bankrupt … again

Splitting J.P. Morgan first would be fitting historically as well, since Dimon’s mentor Weill provoked the repeal of the Glass-Steagall Act, which mandated a separation between commercial and investment banks. Splitting J.P. Morgan could potentially spur the law’s re-instatement while providing a great blueprint for future bank splits.

Regulators need to shape up as well

Just as Weill has called for bank splits, bank and securities regulators should encourage break-ups of the banks as well. The FDIC should get moving on requiring higher depository insurance premiums for banks with risky pay. And regulators should reevaluate how their lack of forthright communication may be harming the markets. While these institutions may not want to share the details of investigations, their testimonies on Capitol Hill should not be one of a few limited venues for communicating their expectations to the market. Regulators should be communicating their expectations for bank and public company behavior so investors and customers understand their rights, and issuers understand their responsibilities.

When looking at the split-up scenario, analysts and the media should take the recent lessons from J.P. Morgan to heart and realize that relying on earnings numbers without looking under the rug produces more harm than good.

Out of J.P. Morgan’s woes comes the opportunity to go beyond setting things right to creating a new standard of excellence along with banks that can be managed. All has not yet been lost.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (
), a board advisory firm.