"Bernanke: Smaller Banks Not Necessarily the Answer"

Ben Bernanke does not want to lose "the economic benefit of multi-function, international (financial) firms," so he is hesitant to break large banks into smaller sized institutions. I don't have much problem with the economics, if there are efficiencies that come with bank size we should exploit them, especially if breaking up banks into smaller entities does little to reduce systemic risk but instead simply fragments the problem into many more pieces (though I'd still like to know where the minimum efficient scale is, anything larger than that is unnecessary). Obtaining resolution authority for banks in the shadow system is also very important, so I don't disagree with the emphasis on this in Bernanke's remarks.

But there seems to be the view that if they have resolution authority, higher capital requirements, etc., that will make the probability of a major breakdown small enough so that the expected benefits of size outweigh the expected costs. While I agree that obtaining resolution authority and other regulatory change is extremely important, I wouldn't bet my house, or housing and asset markets more generally, that this will eliminate the chance of a major breakdown, or make the chance small enough to justify huge, powerful, market-dominating institutions.

I would like to see more effort to measure and regulate connectedness within the system (which can be very high even with banks broken into smaller pieces) since that would add another layer of protection, the degree of leverage should come under scrutiny as well, and I would also like to see more attention to the political risks (e.g. capture of legislators and hence regulation) posed by large financial firms:

Bernanke: Smaller Banks Not Necessarily the Answer for ‘Too Big to Fail’ Dilemma, by David Wessel, WSJ: Mervyn King, governor of the Bank of England, says the solution to banks that are “too big to fail” is to have smaller banks. But Ben Bernanke, chairman of the U.S. Federal Reserve, says he isn’t convinced that’s the best answer.

Mr. Bernanke ... said he would prefer “a more subtle approach without losing the economic benefit of multi-function, international (financial) firms.” ...

Mr. Bernanke suggested alternatives such as higher capital requirements against bank trading books, higher capital for “systemically important” institutions and a congressionally created process for coping with failing big financial firms in ways other than bankruptcy or bail out.

He also expressed interest in what have been dubbed “living wills” — plans that big banks would have to maintain for winding down their operations.

The goal, Mr. Bernanke said, is to reduce “the artificial incentives for size” — including the incentive to grow large so that government bailouts are anticipated — so that financial firms instead grow to a size that is economically valuable in a global economy populated by large multinational companies.

The Fed chairman did emphasize that supervisors should have the authority and willingness to tell the management of a large institution, where appropriate, that it cannot expand unless it improves its management and risk-management capabilities.

Both in answering the question and in his prepared text, Mr. Bernanke again beseeched Congress to act soon to give regulators “resolution authority” to cope with the imminent collapse of a big financial firm other than a bank, and to address other vulnerabilities in the regulatory regime exposed during the crisis.