Is the goal of avoiding the risk of “too big to fail” in regulating banks by keeping them smaller too improbable to work? Yes, according to Avinash Persaud of Intelligence Capital, a financial advisory firm. In a new essay posted today on Vox, he argues that policymakers should instead focus on making “the financial system less sensitive to the error in the markets’ estimate of risk…”

He goes on to write,

In the US, perhaps reflecting a greater belief in markets and a stronger mistrust of regulation, the emphasis has been on finding market-friendly ways to contain the spillover of bank failure. US policy debates are occupied with concerns that banks should not be “too big to fail”; that private investors, not taxpayers, should hold “contingent capital” which carry implicit or explicit conversion into equity in a crash, and that improvements must be made to the functioning of “over-the-counter” markets through greater use of centralised trading, clearing, and settlement. These proposals are less about modifying capital requirements and more about prohibition and taxation and are micro-prudential in nature. Banks would not be allowed to do “risky” things (the “Volcker Plan”) and large balance sheets will be taxed to repay the bailout funds (“the Obama Levy”).

A better approach starts by first recognizing that error in banking is “strongly correlated to the boom-bust cycle.” In other words, there’s only so much that regulation can do, even if it’s enlightened regulation. The business cycle isn’t going away, no matter how many laws Congress enacts. Meantime, policymakers need to emphasize efforts on reducing “the sensitivity of the financial system to the errors of estimating risk” by limiting “the flow of risks to institutions with a structural capacity for holding that risk, and not a statistical capacity.”
“Bank balance sheets bloated by leverage are systemically dangerous,” he continues, “and regulatory or fiscal policy should address this through liquidity buffers and leverage ratios.

But given how contagious crises are, it is likely that what is “too big to fail” is actually small. Any list of institutions that were “too big to fail” conjured up in 2006 would not have included Northern Rock, Bradford & Bingley, IKB, Bear Sterns or even Lehman Brothers. Banks lend to banks. While some are more illiquid than others, they are intrinsically illiquid institutions. It does not take a large failure to lead to panic. High-yielding deposits can fly out of the website almost as quickly as money market funds can withdraw. In a crisis almost everyone is “too big to fail”.

Moreover, we can have as large a boom and subsequent crash, with the same economic misery, in a world of only small banks. Some will recall the 1973-1975 Secondary Banking Crisis in the UK, in which 30 relatively small financial institutions had to be supported by the Bank of England following the preceding property boom. The 1973-1975 crisis rivals, and on some measures exceeds, the impact on the UK of the current financial crisis. It was one of the reasons that developed country regulators began to take a more benign view of large banks snapping up smaller ones. The fashionable argument of the day was that small, competitive, financial institutions were inefficient and had little “franchise value” and so they would under invest in their own longevity – by having less conservative lending practices – than larger, more profitable banks.

Crashes follow booms. Booms are fuelled by some new dawn – normally the arrival of new technology – that makes bankers feel that the world is a brighter place, risks have fallen, and that they are therefore justified in lending and leveraging more. This behaviour is even more acute in the modern age of “risk-sensitive” regulation than in the old-fashioned world of credit and concentration limits and lending rules of thumb. The systemic effect of having one large bank engaged in rapid lending growth is no different than having several small banks do so. It may even be easier to resolve a crisis with one large bank.

“It’s naive to think ‘too big to fail’ is going to go away,” Gil Schwartz, a partner at Schwartz & Ballen LLP, tells American Banker via Regulatory reform “may change the nature of the problem, but I don’t think it will ever go away. It will always lurk in the shadows that an institution is too big to fail and the government won’t let it fail.”
Someone should tell the folks in Washington.