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From "Too Big to Fail" to "Too Many to Fail"


Recognizing one of the biggest fallacies making the rounds in financial and political media.

In my view, one of the biggest fallacies making the rounds in financial and political media these days is that the financial crisis was caused, or at least aggravated, by the fact that many large banks were "too big to fail."

Furthermore, many seem to think that if we reduce the size of financial institutions, never again will our government need to bail out troubled banks.


The financial crisis wasn't caused by a few banks taking on too much risk. The causes of the financial crisis were systemic. This means that forces that go beyond the control of any financial institution threatened the solvency of the entire financial system -- big, medium, and small. The need for bailouts stemmed from the need to not allow the entire financial system fail -- not just the need to save a few large banks.

In a hypothetical future world in which all banks are small and systemically insignificant, crises will continue to occur and governments will have to step in to bail out these banks en masse, because a country simply cannot afford to let its financial system collapse. The cost of such bailouts are much lower than the cost of collapse.

In a systemic crisis, the exact same factors that knock out a big bank will wipe out many small banks. While it's true that the government can, in normal times, afford to allow a small systemically insignificant bank fail, the fact is that it cannot allow many small institutions to fail simultaneously because their combined failure will pose a systemic risks to the entire system. This is a clear lesson from our history that too many people have forgotten.

Systemic banking crises are endemic to capitalism. The fact is that, in a capitalist system, every so often they'll occur. This phenomena is associated with greed, trend following, herding, and the "madness of crowds." This is a function of human nature. You can't eradicate human nature, and you can't ameliorate it in this case by making banks smaller.

If banking crises could be prevented by making banks smaller, then the failure rate amongst small banks should have been substantially lower than amongst medium and large banks. That's not the case.

If a fragmented banking system were more effective at preventing crises, then there should have been few systemic crises between 1800 and 1945. The opposite is true. During the era when the US banking system was most fragmented, the US suffered from devastating systemic crises at least every 20 years on average.

If banking crises develop because banks are too big and there's too little fragmentation and competition, then the Canadian banking system should have failed long ago. As it is, Canadian banks didn't fall into the pitfalls that most small US banks did.

To the contrary, by having an overly fragmented banking system, the costs of regulation and supervision skyrocket, lowering the level of effective supervision per institution.

Furthermore, the utopian libertarian idea that small banks will be regulated by the marketplace through competition is a canard as the average depositor has no clue about how to asses the risks between one financial institution and another.

To make matters worse, the complexity and costs of the inevitable bailouts will be multiplied in a fragmented financial system. Excessive fragmentation of banks creates more risks and costs, not less.


The current popular outcry against "too big to fail" is just another popular delusion distracting citizens from the real causes of the crisis. Ditto for the separation of investment and commercial banking.

Sure, there are plenty of things that could have and should have been done on the institutional and regulatory fronts. (That's a subject of another article.) However, for now I'll merely say that one of the most disturbing aspects of the scapegoating that's going on currently is that it serves to relieve people of their personal responsibility for the crises they're going through. It's easier to blame the banker for lending you too much than it is to blame yourself for borrowing too much.

Financial regulation will achieve relatively little in a society without a strong ethic of personal responsibility.
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