Kevin Drum has nicely posed the question of whether it really is important to break up big banks. After all, he argues, even small-ish banks have proven to be too leveraged and interconnected to be permitted to really fail. He argues that maybe it's the banking industry, rather than individual banks, whose size and reach we need to constrain.

John Hempton has been arguing for the Australo-Canadian model of an oligarchic, heavily regulated, generously profitable banking system.

James Kwak offers a very nice discussion of the "too big to fail" problem in light of the absence of structural rather than supervisory approaches in Treasury Secretary Geithner's recent regulatory proposals. (And Drum responds.)

I think size does matter very much, but not because small banks are inherently small enough to fail. Drum is right about that: Like a dwarf with a suitcase nuke, a sufficiently levered and inter-contracted microbank could take down the world as surely as the Citimonster.

But in practice, a properly defined smallness could add a lot of safety to the banking system:

1. Very directly, limiting size defined by total asset base plus an expansive notional value of all derivative and off-balance sheet exposures limits both interconnectedness and leverage. (Defining size limits by capitalization would suffer from the same drawback as traditional leverage constraints — they encourage bankers to scheme secret ways of levering up.)

2. When a bank appears to be small enough to fail, creditor discipline will backstop regulatory supervision. If a bank is perceived as too big to fail, if its failure in "unthinkable", then clients and counterparties will be lax in managing or limiting their exposures, leaving always circumventable regulation as the only bulwark against becoming too levered and interconnected to fail. (Insured depositors, of course, won't provide discipline, and shouldn't be expected to. But bondholders and derivative counterparties will, if a bank's credit is potentially dodgy.)

3. Smaller banks, even very levered and interconnected ones, can be unwound, merged, or put into receivership. We've managed the failures of even large-ish banks like Drexel, Bear, Wachovia, WaMu, or IndyMac, and we could have managed Lehman in a costly but orderly unwind. But once banks have gone truly mega, we're not sure we can manage it. A bank that is too big too merge without overconsolidating the industry presents special problems. From a taxpayer perspective, we are generally able to unwind smaller banks without guaranteeing non-insured creditors, while we find haircutting the creditors of larger banks impossible, because these unsecured creditors regard failure as unthinkable and fail to adequately provision for the risk.

4. Political economy considerations mitigate against large banks (arguably more deeply in the United States than in Australia and Canada). Particularly if financial firms are segregated by scope (e.g. investment banking distinct from commercial banking distinct from brokerage distinct from insurance), groups of small firms with distinct industry agendas are likely to be less corrupting than huge, critical institutions with a unified management that acts strategically in political circles.

5. Scale breeds agency problems. Earning an extra five basis points on $100B in assets amounts to $50M in extra income a year, a fraction of which can make a manager very wealthy in an eat-what-you-kill bank. Making that same five basis points on a $100M portfolio earns a small bank 50K, a fraction of which amounts to a nice bonus, but not a lifestyle change. For both managers, the downside if something goes wrong is the same: they lose their jobs. The ability to leverage a large balance sheet tempts managers at larger banks to take risks that managers at smaller banks would not find at all worthwhile. (Drum points out that managers of small hedge funds earn huge sums too, but that's really apples to oranges. Hedge fund investors, like stock investors, are generally aware of and prepared to manage investment risk, while bank creditors expect that their money is safe. Hedge funds mostly present systemic problems when their use of leverage puts bank creditors at risk. That can and should be regulated, from the bank side and perhaps by eliminating the right of hedge funds to limited liability forms of organization.)

There are very few obvious reasons why large banks are useful at all, other than supervisory convenience if you think Hempton's regulated oligarchy is the right model. It may be annoying to have to pay other-bank ATM fees, but besides that, there are very few services or efficiencies a large bank can offer that a small bank cannot. Large banks can provide large loans more easily, which is convenient for corporate clients. But that may be a bad thing. Lending decisions can be mistakes. It's one thing if a lending committee misdirects $300K to a bad mortgage. It is much more costly if that same flawed body channels $3B to a crappy LBO. Raising large quantities of capital should require the separate assent of multiple independent parties. Misdirection of the resources represented by billions of dollars creates social as well as private costs.

My sense is that a lot of people think large banks are here to stay for precisely the reason they should be made extinct. Large banks feel modern, important, powerful. It seems nice, somehow, when you travel across oceans and find a branch of your own bank. It's like you are part of a winning team. There's that ubiquitous brand, and it's your brand. But "brand equity" is an important means by which banks build a mystique that makes their failure unthinkable, and charms bondholders and other uninsured counterparties into offering leverage on much too easy terms. Ironically, if banks felt a bit shabby and penny-ante, and if managed failures were regular events, the banking system as a whole would be much safer.

Size isn't everything: Bankers are famous lemmings, and a whole lot of small banks who pile into the same poor investment can fail together like one really big bank. But a thousand little banks are at least a bit less likely to make correlated mistakes than megabanks, which can turn a bad investment idea into a firm-wide mission. One goal of bank regulation, besides restricting size and leverage, should be to encourage independent lending decisions and supervising the diversity of the aggregate banking system's portfolio. Regulators should "lean against the wind" of booms that homogenize banks' asset base by restricting growth of overrepresented asset classes. If there is a good economic reason for a boom, nonbank equity investors can take advantage of the opportunity.

Note: Ideally I prefer a complete separation of the depository and payments function of banks from the lending and investment function. That is I'd prefer we create "narrow banks" that invest only in government securities, and define a new kind of explicitly at-risk investment fund to serve the traditional purposes of bank lending. But this piece is written under the pessimistic assumption that we'll leave the familiar structure of banking intact.