Will small banks replicate big banks?

By Felix Salmon
November 12, 2009
Mark Gimein says that we shouldn't worry too much about the problem of too-big-to-fail, because the alternative to one big bank failing is lots of small banks failing:

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Mark Gimein says that we shouldn’t worry too much about the problem of too-big-to-fail, because the alternative to one big bank failing is lots of small banks failing:

What we’ve seen in virtually every crisis is that bank failures and other economic catastrophes are highly correlated, in large part because financial players do not lock themselves up in rooms and gaze at crystal balls. They watch what everyone else is doing and then they do the same thing… The problem of the giant institution that’s an outlier and needs to be bailed out when everyone else is doing fine is one that exists only in theory. What happens in practice is that many banks, large and small, make the same mistakes and fail at the same time. In other words, it tends to be not single banks that need to be bailed out, but big swaths of the whole industry. Breaking up the biggest banks won’t change that.

This misses two key points. The first is that big banks are too interconnected to fail in a way that small banks never are. And the second is that big banks have balance sheets which are so enormous that they can hide all manner of nuclear waste there (as well as in purpose-built off-balance-sheet vehicles) in a way that small banks could never comprehend. Yes, there have been a lot of small bank failures over the course of this crisis. But none of them were a result of those small banks keeping on their own balance sheets a huge quantity of unfunded super-senior tranches of synthetic collateralized debt obligations. You need to be big to be that stupid.

When small banks fail, it’s generally because they make long-dated real-estate loans at high valuations or low interest rates or both. Big banks, by contrast, can fail ways that small banks can never dream of. And when they fail, the consequences for the payments system generally can be disastrous. So yes, breaking up big banks does significantly reduce tail risk in the financial system. No matter what Goldman Sachs says (and they’ve been feeding me the Gimein line for a while now).

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