Why Big Banks Should be Smaller

James Kwak wants to make US financial institutions smaller:

There are a few main things that made companies like AIG and Citigroup systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities…

Size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities).

Kevin Drum is not convinced:

It still has the flavor of a solution that’s clear, simple, and wrong. After all, Bear Stearns was a quarter the size of Citigroup, and it was considered too big to fail. So just what would the limit be on bank size? $500 billion in assets? $200 billion? Can a country the size of the United States even have nationwide banks with limits like that? And what happens the next time around, when all these smallish banks overleverage themselves and collapse en masse? Are we any better off than we are with a few big banks failing?

I’m with James on this one. Two things are worth noting about Bear Stearns: first, it might have been small by Citigroup standards, but its balance sheet was still enormous. And secondly, it wasn’t considered too big to fail, it was considered too interconnected to fail, largely as a result of its role as a major CDS broker.

To get specific, I think that maybe $300 billion in assets would be a reasonable cap on bank size — there’s very little evidence that banks get any economies of scale beyond that in any case. If they want to be part of a global or even a national network that would be fine — I’m sure such networks would spring up quite naturally, much as they have in the airline industry. After all, the United States managed to go 200 years without any nationwide banks, it’s unclear why it desperately needs them now.

At the same time, the cap on the balance sheet of broker-dealers should be smaller still: the more interconnected you are, the lower the cap, to the point at which companies like the CME, which are far too interconnected to fail no matter how small their balance sheet, should be barred from issuing any liabilities at all.

As for what happens when lots of smallish banks overleverage themselves and collapse en masse, well, you get an S&L crisis. Which is fiscally painful, to be sure, but which can largely be avoided through good regulation and which more importantly doesn’t have anything like the systemic implications of the current meltdown. So yes, we’re better off with one of those than we would be with Citi and BofA both failing.

The problem is a practical one: how do we get there from here. There are no good and politically-feasible answers to that question. So in the real world, TBTF banks are here to stay. But that doesn’t mean we have to like it.