Many people in the financial reform debate keep insisting that the big banks be broken up -- so that they'll be small enough that we can let them fail.
"Too Big To Fail" is indeed a huge problem, but the answer is not randomly capping the size of financial institutions.
The right way to eliminate "Too Big To Fail" is to create a mechanism by which any financial institution can fail without taking the system down with it. This is easily accomplished by forcing the banks to include mandatorily convertible securities in their capital structures.
What are "mandatorily convertible securities"?
They are bonds (debt) that automatically convert to equity if the bank's equity capital level falls below a certain threshold. (Conversion can also be triggered by other events, such as the stock price falling below a certain level, but in our opinion tying conversion to the equity-to-debt capital level is the best way to go).
How does this mechanism work?
If a bank gets in trouble and starts writing off huge loan losses, its equity falls. If the equity falls below a certain level, the mandatorily convertible bonds automatically convert into equity, thus replenishing the bank's equity capital. To provide a further cushion, there could be several layers of mandatorily convertible debt: The first tier converts, then the second, and so on.
Buyers of the mandatorily convertible bonds would know what they were buying, and the bonds would be priced accordingly. The yields would be higher than for senior debt, but the risk of conversion would also be higher.
What do mandatorily convertible bonds accomplish that the current system doesn't?
They eliminate the need for the government to step in and save the institution with taxpayer money. The new equity capital will come from the bank's private lenders, as it should.
These securities could also be combined with new regulations to give the FDIC the ability to step in and restructure any financial institution, just as it can already with registered banks. Thus, if a management team is so incompetent that it forces conversion of its mandatorily convertible debt, the management team can quickly be fired. If necessary, the bank can also be broken up and sold off--but any losses will have been funded by the bank's private lenders and shareholders, not the taxpayers.
So that's the right way to deal with "Too Big To Fail"--create a mechanism by which a firm of any size can fail.
So why not just deal with TBTF the other way, by chopping up all the banks into little pieces that are all small enough to be able to fail?
Two reasons.
First, our big banks are competing on a world stage. They compete against huge European and Asian banks. We might be able to limit the size of our OWN big banks, but Europe and Asia aren't going to follow suit. And that means that our big banks will be at a major competitive disadvantage in global banking. Major companies will always borrow from the banks that give them the best terms, and the biggest banks will be the ones who can give them the best terms.
Second, whatever size cap is created is going to be arbitrary. What's "too big"? Why? Is it okay to let a firm with $99 billion of assets fail, but not one with $101 billion of assets? The fights over what's too big and how to determine this will take years (and, ultimately, be meaningless).
Bottom line: Too Big To Fail is a huge problem. But the way to solve it is NOT to chop the banks up into parts.