With Failed Banks, Bigger Might Be Better

There seems to be a consensus that the severity of last fall's financial meltdown was exacerbated by the existence of big, interconnected banks. And so the hunt is on for regulations that will prevent banks from becoming "too big to fail." But is it possible that when it comes to shuttering failing banks, bigger is better?

The premise behind discouraging banks from getting too big is that the failure of big, interconnected banks threatens "the system" and makes bailouts unpleasant but unavoidable necessities. The logic is that if the banks were smaller, the failure of one or several would not necessarily bring down the whole edifice of finance. If firms were smaller, regulators would have an easier time letting them fail, without the knock-on effect of failing behemoths causing chain reactions of failure.

A parallel concern is that the "interconnectedness" is abetted by vast pools of unregulated derivatives. These derivative contracts are the force behind the contagion effect. Because large firms owe huge amounts to one another through derivative claims, the failure of a single systemically significant firm threatens its counterparties, and spreads out of control like a wildfire. Perhaps the only idea that has as much currency as busting up behemoths is the need to regulate derivatives.

Recently Citadel chief Ken Griffin wrote in the Financial Times advocating central clearinghouses for derivatives. He pointed out that 5 big banks hold 97% of all derivative exposures in the banking system. The creation of clearinghouses for derivatives is a good idea, and the industry was moving in that direction before the crises hit.

But another way to look at same data would be to observe that only 3% of the exposures fall outside the top five banks. The big banks are largely a closed system, trading mostly with each other. This presents another way of looking at the problem of bigness. Perhaps it is a blessing in disguise.

It has always been puzzling why this concentration of risk was not viewed as potentially a good thing. If last fall the biggest banks were either so undercapitalized or so heavily exposed to one another that they would have failed but for government assistance, was it not better that most of their claims were against each other? It seems that this high concentration of risk among relatively few players should have made the job of regulators far simpler. If these banks had been shuttered the risk to the system should have been manageable, at least in dollar terms, since only 3% of it resided outside the community of the Big 5.

Letting the large, interconnected firms fail would mean the bulk of the losses would have been borne by the creditors and stockholders of these banks. What regulators failed to do last fall was close down the weakest banks and declare the remainder healthy. Of course, they could only have done this if they knew the condition of the banks they regulated. Treasury Secretary Geithner's Stress Tests - completed 8 months after the crisis struck -- taught us more about the competence of regulators than they did about the precarious capital of the banks.

As the unemployment rate marches higher in lockstep with reports of growing bonus pools at the large banks, Main Street is asking, just what was salvaged by these bailouts? A proper concern of regulators is to protect those downstream from the giant banks from being exposed to their failure. But there are better - and probably cheaper - ways to avoid such contagion.

One approach would be to name the Federal Reserve Bank of NY or some similar risk-free entity as the omnibus counterparty to the Failed Banks. So if a failing Citibank has an interest rate swap on with a municipality in Arizona, that municipality would now face a risk-free counterparty. It would be an administrative challenge, but the cost to taxpayers should be far lower than propping up Citibank and Bank of America in perpetuity.

The FDIC has shuttered over a hundred banks this year, and hundreds more are expected to fail in the next few years. There has been some argument in favor of the operating efficiency of large banks. The point is debatable, but it seems obvious that closing one $100 billion bank is easier than closing one hundred $1 billion banks.

The premise that the insolvent banks were too big and interconnected to fail needs further examination before we concoct schemes to shrink them, or tax them into some optimal size. An alternative thesis would consider that regulators, co-opted by the big banks, missed an opportunity to wipe the slate clean and start over with a healthy remnant.

By placing the emphasis on "too big to fail" regulators can avoid the scrutiny they deserve for mismanaging the crisis. And they can continue to insist that nothing could have been done differently. In reality, the difficult work of closing big banks was passed over in favor of massive bailouts, and the bill due to bank creditors was handed to taxpayers. Were the big banks really too big, or were our regulators too small for their jobs?