Proponents of bank size limits as a solution to the moral hazard problem induced by bailouts implicitly assume that the combined portfolio of a collection of smaller banks will be less risky than the portfolio of a large bank of equivalent size. This assumption is unwarranted, we contend. In fact, the very prospect of government bailouts creates an incentive for banks—regardless of size—to take on highly correlated risks, which, in turn, raises the likelihood of financial crisis.Which may seem obvious, until you think about the solutions that have been proposed in legislation like Dodd-Frank.
This paper argues that limits on bank size miss the point. What truly matters to the well-being of the broad economy is not the risk profile of any given bank portfolio, large or small, but the risk profile of the entire banking system. Regulators therefore need to understand what kinds of events are likely to threaten a significant fraction of the aggregate assets of the entire banking system, rather than concentrate (as current policies do) on a limited number of large banks. In particular, they must focus on how the portfolio of the entire banking system is exposed to such events. Regulation of a given bank then should deal with whether that particular bank’s behavior is mitigating or aggravating the risk exposure of the entire system. In brief, we need stress tests of the entire banking system, not just of individual banks.Which is not what we have currently.