Not unusually, I was a bit incoherent in my previous post on bank size. On the one hand, I wrote...
...a sufficiently levered and inter-contracted microbank could take down the world as surely as the Citimonster.
On the other hand...
...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.
If limiting size constrains leverage and interconnectedness, how could a microbank get to be so interconnected and level as to bring on armageddon?
The key, of course, is in the definition of size. Entities that are small in terms of number of people involved and level of capitalization certainly can blow things up, by loading up on traditional leverage (debt) and untraditional leverage (derivative exposures, off-balance-sheet contingent liabilities). AIG might have been a big firm, but the unit that blew up the world amounted to a handful of people in a well-appointed London garage. The "bigness" of AIG mattered only insofar as it permitted that tiny operation to lever up, by taking on trillions of dollars in notional CDS exposure.
But if size is defined properly to mean the total scale of assets to which a firm is exposed, including balance sheet assets plus the notional value of any derivatives plus any off-balance-sheet commitments, then size is basically everything. Suppose there was a bank levered 10000:1. Sounds pretty bad, huh? But suppose the bank has precisely one penny of equity against a hundred dollars of assets. That might suck for the fool who lent the hundred bucks, but the rest of us can sleep easily. Leverage alone can't cause crises: it's only when an entity is levered up to some systemically troubling size that bad things happen.
That doesn't mean we could regulate bank size and then ignore leverage: If all banks had $100 on assets against a penny of equity, we'd end up with a lot of bank failures, creditor bailouts, and sleepless nights. What size limitations do is prevent mistakes or misdeeds at any one or few firms from becoming all of our problem. Smallness also reduces the likelihood of misdeeds, since dumb gambles have a bigger payoff for managers at big banks than at modest thrifts. Some banks will always slip through regulatory cracks. If they are small and few, that's not a problem. If they are big or many, we're screwed.
Size limits, like leverage and risk constraints, will inevitably be gamed. There will always be fuzziness surrounding what sort of contingent liabilities should fall under a size calculation, and bank lobbyists will work assiduously to create loopholes. Adding hard limits on size and trying to police them won't be a panacea. But faking small might be harder than faking well-capitalized. Plus, forcing banks to appear small may help to keep banks actually small, since counterparties get nervous about offering sneaky, uncollateralized leverage to banks that look like they are small enough to fail.
In the end, banks-as-we-know-them are flawed by design. They serve an important purpose, but do so in a manner that is predictably prone to failure. If your roof has a leak and water drips in, one way to handle the problem is with a bucket. That approach can be effective, but it demands constant supervision. There is always the danger of some lapse of attention, then whoops!, the bucket overflows and your floor is ruined. Resolving to watch the bucket very carefully by, say, titling yourself the integrated bucket super-regulator might help, a bit. But even super-regulators need the occasional bathroom break, and buckets are notorious for tempting super-regulators with songs of free water flows and offering cushy jobs if they look the other way. Imposing size and leverage constraints on banks is like replacing a small bucket with a big washtub: You'll still have problems if you don't watch the thing, but the occasional lapses in supervision are less likely to conjure the Great Flood. Of course, the best way to manage a leak in the living room would be to stop messing around with buckets and patch the roof instead. To do that, in my opinion, we'd have to separate the credit and investments function of banks from the payment and deposits function, and draw an enforceable bright line between guaranteed claims and risk investment.
But if we're too scared to climb that ladder, I suggest we get the biggest washtub, — I mean, the tightest size restrictions — that we can possibly manage. Promising to stare very sternly indeed at the same old bucket just won't cut it.
p.s. if you haven't seen it, I really like James Kwak's Frog and Toad post on the difference between supervisory and structural approaches to regulation.