02/23/2009 05:12 am ET | Updated May 25, 2011

Too Big to Succeed

The constant creation and destruction of companies, industries, and ideas is a force known as creative destruction and is a cornerstone of capitalism. Without the risk of failures like bankruptcy, where is the incentive to work harder, to develop a better product, to improve efficiency, to take chances? Bankruptcy also provides another important function: it frees up capital and talent to pursue better opportunities. Think of Google's parabolic growth over the past eight years. How many of those new employees were from companies that had failed when the dot-com bubble burst? Would there have been money to fund the next round of companies like YouTube or Facebook if venture capitalists had not allowed many of their earlier investments to fail, instead of continually throwing good money after bad?

Which brings us to the real question: if these naturally occurring forces have proven themselves effective so many times across multiple industries, decades and centuries, why do we fight it so defiantly when it comes to banks? The obvious answer is that banks are different because we as consumers have our money there. If a Silicon Valley startup files for bankruptcy, the only likely losers are their ostensibly wealthy investors, and possibly their lunch catering company. However, when a bank fails, the potential losers are every depositor in the bank, as was demonstrated during the Great Depression. The federal government tried to alleviate this fear by creating the FDIC which acts as "insurance" for bank customers against a possible bankruptcy. This worked for awhile until a combination of deregulation and increased bank mergers led to the rise of huge behemoths whose total deposits far exceed the FDIC's or anyone's ability to insure them.

All successful insurance models are based on the theory that the maximum size of any individual claim is a tiny fraction of the money available, and the odds of a large percentage of clients filing claims at the same time is very, very small. Auto insurers spread their risk through millions of car policies across the country and no single claim from any client can have a large impact on their overall reserves.

Recent numbers from the FDIC suggest that it currently has approximately $55 billion on hand. The FDIC also has lines of credit with the Treasury department for situations where its cash on hand proves inadequate. This all sounds well and good until you look at what it's charged with insuring. By its own math, The FDIC estimates that the $55 billion of reserves is insuring $4.4 trillion in deposits, a 1.25% ratio. The problem with this is not the ratio of reserves; it's the distribution of deposits. Bank of America, as an example, currently has more than $600 billion in deposits. That exceeds 10x the amount the FDIC currently has and more than the US government has injected into the entire banking system to date. The 6 largest banks by deposits have over $2 trillion in combined deposits, almost 50% of the total of the country's bank deposits.

As if this weren't enough, these same 6 banks have issued mountains of debt, thus amplifying any potential bankruptcy across the financial system and potentially leading to a complete banking system collapse. This is the definition of "too big to fail".

And that brings us to our current situation; we have created these monsters which require constant care and feeding in the form of taxpayer's dollars. If we don't take care of them, they can destroy our entire economy. What we don't appear to understand yet is that no amount of money, time or regulation can possibly resolve this problem while these few banks continue to hold the entire nation hostage. Even if the economy turns, housing prices rise and companies begin hiring again, we cannot have a robust financial system until these leviathans are no more. Unfortunately, government action to date has only exacerbated the situation. A combination of forced mergers and poorly structured government capital infusions has led the US taxpayers to contribute $45 billion in cash to one banking institution while guaranteeing $98 billion in potential loan losses. What do we get in return for our money? Not much of value; that gives us a 6% stake in Bank of America, whose entire market capitalization was only $36 billion as of Friday.

These banks need to be broken up and a clause added to the FDIC requirements to prevent banks from participating in the FDIC program if their total deposits exceed a certain ratio of the FDIC's available funds. This will have the dual impact of creating a far more diverse set of banks with many more competing ideas and business models. The FDIC will also be left with ample funds to cover individual bank failures and restart the critical process of creative destruction. I look forward to the day when the media has to the same shocked reaction to the failure of a bank that made bad lending decisions as they did when went bankrupt by blowing a large portion of their funding on sock puppets and super bowl ads.

Standerfer is the Executive Vice President of Financial Services for S3, an Austin, Texas company that manages trading information for most of the country's major financial services firms.