Is "Too Big To Fail" Overblown?

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There’s no doubt that banks like Citigroup (C), Bank of America (BAC) and Goldman Sachs (GS), continue to pose significant risk to the system, for if they were to have a “run” or simply blow-up, the cost to do a total rescue would be huge — and they idea of letting them fail isn’t so pretty either.

But we’ve already had 50 small bank failures this year, and Sheila Bair supposedly told Jim Bunning that the number could rise to 500. And of course, the combined market share of all the tiny, community banks is dwarfed by the market share of the few concentrated behemoths.

While no individual small bank could pose systemic risk, clearly a big enough wave of small bank failures would precipitate the same crisis, if an equivalent number of deposits were put at risk.

Now, if you had enough heterogeneity in the banking sector, a tidal wave of failures is unlikely, but it’s not clear how you can ensure this. In fact, we fear, small banks are likely becoming more homogeneous.

Information on “best practices” can spread far and wide and fast. The rash of failures in Illinois were all the result of banks pursuing the same, risky funding strategy. Same with Atlanta. Banks clearly have a tendency to cluster around risky (and short-term profitable) strategies.

To solve the problem of banks that are too big, many are proposing some kind of “tax” on bank size. As you acquire more, you might pay a bigger tax, or your reserve requirements would go up, but this could have the effect of pushing the most risk-hungry operators to small banks, where they can still push for huge personal paydays, with lower restrictions.

Bottom line, it’s not clear why if we broke Citigroup into, say, 100 smaller deposit banks, that we’d have any net reduction in socialized risk.

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