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SAN FRANCISCO (MarketWatch) -- If policymakers and regulators tackled the issue of too big to fail head on, the largest U.S. financial-services companies would be downsized dramatically, leaving the industry looking more like the utility sector: safe but slow-growing.

Bank of America, J.P. Morgan Chase , Wells Fargo , Goldman Sachs and Morgan Stanley are among the leading candidates to be broken up or shrunk significantly under such a drastic scenario, which has gained noted supporters in recent weeks.

"What you will have is another public utility sector, with banks growing roughly 4% a year, funded by deposits," Richard Bove, a financial-services analyst at Rochdale Securities, said in an interview.

For a vision of such a future investors need look no further than Citigroup Inc. , which is already being broken up under part-ownership by the government, Bove and other analysts say. American International Group, almost 80% owned by taxpayers, is also being slowly unraveled.

Since the financial crisis hit last year, the U.S. government has spent hundreds of billions of dollars investing in the nation's largest financial institutions, lending them cheap money and guaranteeing their debt.

While the effort probably averted another Great Depression, it's created a cadre of financial-services behemoths that are too big to fail.

Proposed reforms aim to prevent costly bailouts in future. But critics complain that these reforms could end up doing the opposite, by giving top institutions more-explicit government backing. That, in turn could lead to more risk-taking and even larger companies.

Radical solutions

As the reform proposals are chopped and changed in Congress, more radical solutions to the problem are gaining support.

Former Federal Reserve Chairman Alan Greenspan said on Oct. 15 that regulators should consider breaking up institutions considered too big to fail.

Such firms can borrow more cheaply than rivals because investors know the government will bail them out. That cuts competition and imperils the financial system, he explained during a speech to the Council on Foreign Relations in New York.

In the late 1990s, Greenspan supported rolling back the Glass-Steagall Act, a Depression-era law that prohibited commercial banks from owning or working with brokerage firms or participating in investment banking activities.

But last month, he said that, while arbitrarily breaking up institutions went against his philosophical bent, something must be done to tackle the too-big-to-fail issue.

Mervyn King, governor of the Bank of England, recently proposed separating traditional banks, which benefit from government-backed deposit insurance, from riskier market players. He also said it was hard to see why breaking up large financial institutions would be impractical.

"What does seem impractical, however, are the current arrangements," King said. "Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are."

'Absence of rules'

The current approach to financial reform is creating uncertainty among investors, because it's not clear what the government and regulators want to do with the industry, according to Nancy Bush, a bank analyst at NAB Research LLC.

Separating commercial banking and investment banking again would be "extreme," but it may be better than the confusion caused by recent regulatory efforts, she explained.

"Somebody should make a decision. We have no rules right now, and in the absence of rules, investors flee," Bush added. "We don't know capital requirements, or who will fail, or how many wounded players will be allowed to limp along, tainting the rest of the industry."

If Glass-Steagall is brought back in a new form, "at least we would know what to expect," she concluded.

Downsizing

Economist Henry Kaufman, a former Salomon Brothers executive who was on the board of Lehman Brothers , favors downsizing institutions so that if they fail, they won't threaten the financial system.

In 1990, the ten largest U.S. financial institutions held about 10% of the country's financial assets. Last year, they held over 60% and the 20 largest probably held at least 80% of financial assets in the nation, Kaufman estimates.

This "financial concentration" gained momentum after Glass-Steagall was repealed and it accelerated again in the past year as the government bailed out the largest institutions, he explained.

"At a minimum, we should have financial public utilities," he said in an interview. "Preferably we should have institutions that are small enough so that when they fail, they just fail."

Cap on assets

Simon Johnson, an MIT professor and former chief economist at the International Monetary Fund, reckons there should be caps of roughly $100 billion on the assets of financial institutions and "serious criminal consequences" if firms are caught trying to get around such limits.

That would leave the industry with more, smaller firms with different specialties. But it wouldn't necessarily reduce profitability, he said.

Goldman had almost $900 billion in assets at the end of September. Just over a decade earlier, the firm had a little more than $200 billion in assets, but was still very successful, Johnson explained.

Lehman grew at a similar pace. In late 1998, the firm had $191 billion in assets and by May 30, 2008, a few months before it collapsed, assets stood at $640 billion.

"The lesson of Lehman should not be that the government should have prevented its failure," David Einhorn, head of hedge fund Greenlight Capital, said in a recent speech. "The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system."

The same logic applies to AIG, Fannie Mae , Freddie Mac, Bear Stearns, Citigroup and "a couple of dozen others," he added.

'Laboratory experiment'

Citigroup, roughly a third owned by the government, is already being broken up, giving investors a preview of how other large financial institutions may be shrunk in future.

"The break-up of some of the banks has already occurred," Bove said. "Citigroup doesn't really exist anymore."

Late Thursday, the company unveiled plans for an IPO of its Primerica business, which sells life insurance, mutual funds, variable annuities and other financial products.

Citigroup sold its Smith Barney brokerage business to Morgan Stanley earlier this year and had already jettisoned most of its insurance operations.

Other businesses sold include its money-management arm, retail bank networks in Germany and Puerto Rico, brokerage, banking and consumer finance operations in Japan, Diner's Club and other credit card portfolios, payment processing businesses in the U.S., India and Brazil, and a controversial energy-trading unit called Phibro.

Businesses that remain on the block include Commercial Credit, The Associates, most of its mortgage, auto and student-loan portfolios and possibly its Mexican bank, Bove said.

Citigroup had $2.4 trillion in assets in September 2007 and this has declined to $1.9 trillion in two years, the analyst noted.

Citigroup has housed all the businesses it doesn't want in Citi Holdings, while the operations it wants to keep are in Citicorp.

The remaining institution will have roughly $1 trillion in assets, with a leading credit-card business, a large retail bank in New York, a medium-sized retail bank in California, a clutch of small private banks globally and a top payment-processing and lending business, Bove said.

"The Treasury Secretary and numerous other bank regulators have spoken repeatedly about the need to gain the power to liquidate companies that pose systemic risks," the analyst wrote in a recent note to investors. "Citigroup is the laboratory experiment to show how it can be done."

Who's next

Bank of America , which has also received a lot of government support, is the next candidate to be broken up, Bove said.

The company is a leading retail bank in the U.S., which means it benefits from a large source of government-backed funding in the form of guarantees provided by the Federal Deposit Insurance Corp.

However, Bank of America acquired Merrill Lynch at the height of the financial crisis last year. Merrill is a leading broker and investment bank, with riskier capital markets operations that almost brought it to its knees last year.

Bank of America may come under pressure to sell such capital markets businesses in future, Bove and others said this past week.

Wells Fargo also got a capital markets business when it acquired struggling rival Wachovia last year. Wells mostly avoided investment banking in the past, focusing instead on mortgages, retail banking and commercial lending. However, the company said earlier this year that it decided to keep Wachovia's capital markets business.

J.P. Morgan Chase , one of the largest retail and commercial banks in the world, also has a leading investment banking business and is one of the biggest players in the derivatives market.

The capital markets businesses of these institutions have generated big profits this year as equity and credit markets rebounded.

"Depositors are once again financing the whims of Wall Street," James Chanos, head of short-selling hedge fund firm Kynikos Associates, said during an Oct. 22 speech at the University of Virginia.

Shareholders and bankers are reaping the rewards, while depositors bear the risks and taxpayers bear the ultimate risk, he explained.

Bove reckons J.P. Morgan, Wells and Bank of America may all be pressured to sell their capital markets divisions and other riskier businesses.

Goldman, Morgan Stanley

However, if these capital-markets business are separated from their commercial bank owners, many of them would probably still be too big to fail.

Lehman Brothers collapsed partly because it wasn't supported by a more stable source of funding from government-backed retail deposits.

Indeed, Goldman and Morgan Stanley were quickly granted Bank Holding Company status by the Federal Reserve as Lehman filed for bankruptcy. See full story.

The move gave Goldman and Morgan Stanley permanent access to emergency loans from the Fed if they need the money.

In return for that government back-stop, the firms are expected to be more tightly regulated and face more limits on riskier activities. However, Goldman has followed a business-as-usual strategy this year, generating record quarterly profit. See full story.

Bush of NAB Research reckons Goldman and Morgan Stanley should have their bank holding powers taken away.

"That has given them an explicit government guarantee by allowing them to borrow at Federal Reserve's window," she said. "Those companies need to be on their own, period, and that should lessen risk taking."

However, the firms would probably still be too big to fail., Kaufman said, adding that the only way to change this is to shrink the firms and limit many of their activities.

Kaufman recommends limiting or banning proprietary trading, which is trading investment banks do with their own money.

Limits should also be imposed on the amount of money they can invest in outside affiliates and the amount of assets they can securitize, Kaufman said. He also thinks their participation in the derivatives market should be limited.

While Goldman has thrived this year, some analysts are concerned about the future, even if the firm retains its Bank Holding Company status.

"Goldman will face a significant challenge as the firm brings itself into compliance with the new regulatory rules for a Bank Holding company which we believe will constrain its core trading businesses," Brad Hintz, a securities industry analyst at Bernstein Research, wrote in a note to investors in late September.

Exemptions

Still, Goldman has said it's in the process of converting to a financial holding company structure, which is different from bank holding company status, Hintz noted.

Financial holding companies are given a longer leash, allowing them to underwrite securities offerings and get involved in a wide range of trading and merchant-banking activities, the analyst explained.

Under these rules, firms are even allowed to trade commodities so long as they entered the market before 1999. Goldman bought its commodities-trading arm J. Aron & Co. in 1981. See spotlight on Goldman's commodity business.