"Too Big to Fail" vs. "Too Small So We Failed"

A couple of weeks ago I argued that having "too big to fail" banks might actually be a good thing, or at least that the alternatives might be worse. Here's a few more reasons why this makes sense. First, because without large banks it's impossible to deal with many bank failures. How? Well, if you cap bank size, then who's going to buy the banks that fail?

In addition to being a jaw-droppingly superficial idea overall, here’s another reason why breaking up the banks and capping their size would be a titanic mistake. Everyone seems to agree that normal, non-TBTF banks can be resolved without causing a meltdown in financial markets. This is, in fact, the justification given for capping bank size — it would make all banks “small enough” to be resolved smoothly, which means that no single bank failure would pose systemic risks. Mission accomplished! Of course, this argument quickly breaks down when you think for more than 15 minutes about how the FDIC resolves failed banks.

The FDIC resolves the vast majority of failed banks through what’s known as “purchase and assumption” agreements, or P&As. P&As are transactions in which a healthy bank purchases some or all of the assets of a failed bank and assumes some or all of the liabilities, including all insured deposits. ...

But think about how potential acquiring banks would respond if the FDIC approached them and offered them a waiver on the $100bn cap in exchange for agreeing to a P&A. They would think:

"Well, the government begged JPMorgan to buy Bear and begged BofA to buy Merrill, but then the government turned around and forced JPM and BofA to break themselves up a few years later! So thanks but no thanks, Sheila, we’re not interested in buying a bank that you’re just going to force us to divest in a couple years.”

So with a cap on bank size, P&As would likely be off-the-table for the largest bank failures. But if the FDIC can’t use P&As, then it can’t ensure that the largest banks will be resolved smoothly—and thus pose no systemic risks—even with a cap on bank size in place! And if the FDIC can’t ensure that the failure of the largest banks won’t pose systemic risks, then what was the point of the cap on bank size in the first place?

In other words, imagine what the world would look like right now if JP Morgan couldn't/wouldn't buy Bear Stearns, or if Bank of America couldn't/wouldn't buy Merrill Lynch. It's a world with several other Lehman-type collapses, many more small bank failures (there was 140 in 2009, with potentially hundreds more still to come), and a broader systemic collapse. Either that, or a much larger public intervention than we actually had.

In fact, that's exactly what happened during the Great Depression:

Indeed, one of the major contributors to bank failures during the Great Depression was the National Banking Act of 1864. That law, according to monetary historian Jeff Hummel, an economist at San Jose State University, banned any branching (interstate or intrastate) by nationally chartered banks, except for a few grandfathered banks. Because banks during the Great Depression were so small, they were undiversified. So when the agriculture sector went under, in part because of the Smoot-Hawley Act that attacked free trade, many rural banks failed. Call it "too small, so we failed."

It's possible that the relationship between bank size and systemic stability is parabolic: at first there are increasing returns, then those flatten and eventually recede. But if that's the case, I've not yet seen an argument as to where the "socially optimal" margin lies, if such a thing could even possibly exist. As a rule, arguments in favor of shrinking the banks do not discuss unintended downside consequences. That is reason enough to be suspicious.