Too Big to Fail. It’s not just a description, it’s a political mantra – we have banks which have grown to the point where government cannot manage a potential collapse and the whole system goes down. Why not just bust them up?

There are actually a lot of good reasons why something much more subtle has to be done, as well as something more comprehensive. That doesn’t sell as well on the campaign trail, where the evil banks are a handy villain for all of our economic ills. Yet it’s vitally important because it’s entirely possible that in a rush to regulate we might do something which is not only dangerous but misses the real problem entirely.

It’s interesting how the traditional view of a bank looks like the Parthenon.

We’ve written about the problem many times in the past. To Barataria, the real problem isn’t so much “Too Big to Fail” (TBTF) as it is “Too Big to Understand”. The finance system which keeps our economy keepin’ on is full of a lot of strange and risky “innovations” that very few people really have a good handle on.

Barataria can take credit for the pithy phrase “Banking should be boring”, which has at times entered the popular lexicon. And it should.

But modern banking is far from boring, as we saw in 2008. When Lehman fell, banking was heart-stopping excitement from one headline to the next. Real innovation naturally comes in a world where failure is an option, but how much failure can we accept? A general failure of our banks would put an end to credit, which is to say an end to everything America has come to stand for and rely on in the post WWII era.

You can stop reading now if you think that’s not necessarily a bad thing.

It’s hard to get past this image when nasty stuff keeps happening.

Revisiting bank regulation is necessary because additional resiliency is clearly needed in our credit systems. The basic principle is that no bank should be Too Big to Fail, and no one working in them should ever be Too Big to Jail. No one disputes this. But does it make sense to simple break up big banks and keep them from being too big?

Let’s start with the goal – no single institution or group of institutions should ever be a threat to the entire system.

Immediately, there is a problem. What kind of institutions are we talking about? If you look at the recipients of the Troubled Asset Relief Program (TARP) in 2008, half of the $613B went to the top four recipients – Fannie Mae, Freddie Mac, AIG, and GM. None are banks – they are two government sponsored mortgage packagers, a re-insurer, and an auto company that got into trouble largely through its consumer credit arm (which it came to rely on more than making cars). Overall, 72% of TARP went to non-banks.

This is the first problem with any new regulatory regime – it can’t only target banks. It has to take into account every institution that manages debt and credit.

What does Neel Kashkari know that you don’t?

Even if we do focus on banks, is the problem genuinely size? The short answer is that the issue is more about risk – and size is only one factor. Neel Kashkari of the Minneapolis Federal Reserve has received a lot of attention for his new attempt to study the problem and develop a regulatory regime which might well include a break-up of the largest banks. It should be considered, after all. There’s no point in starting a full study with one option off the table. But that does not mean that a focus on size alone makes sense to anyone – including Kashkari.

Thousands of small banks taking unreasonable risk is just as big of a threat to the system as one big one doing the same thing.

How do we evaluate risk then? There are essentially two types of risk which are of concern to the system. They are internal risks that the institution will fail and the externalized “socialized risk” that is passed on to the government and the market. The last two are essentially the same thing if you presume something like TARP is always going to be in our future. And that makes for a much more interesting assumption all around.

What’s the risk?

Internal risk is relatively easy to evaluate, assuming you can group whatever investments an institution has into categories of risk – assigning them numbers. This brings to mind the failure of bond rating agencies in the era of “liar loans” circa 2006. Some kind of audit of ratings is essential, which absolutely no one talks about. Given a good assessment, however, the amount of reserve capital a bank of any size is required to keep on hand can be calculated such that they have at least a very low risk of failure.

Market based risk is a bit trickier – but it comes with a good model for handling it.

When an ordinary commercial bank fails, the Federal Deposit Insurance Company (FDIC) swoops into action. Often, they take over a failing bank on Friday, fire everyone at the top, clean up the mess, recapitalize the place with a loan, and open up on Monday like nothing ever happened. They can do this because they have the financial resources from required FDIC insurance payments and the staff on hand to make it happen.

Oooooouch!

Externalized risk can also be calculated and an appropriate insurance payment forced on financial institutions doing business in the US. This would include anyone extending more than a certain amount of credit every year, regardless of whether their name is GMAC, Bank of America, AIG, or Bob’s Supermarket.

After all this, might it still be necessary to break up big banks? Perhaps. It may be very difficult to calculate the systemic risk created by a large institution after all. But how should they be broken up? Along what lines? Keep in mind that even if Glass-Steagall was still the law of the land JP Morgan would be about the same size it is today – their commercial banking arm is tiny and insignificant.

While there is a need for a new regulatory system, chanting “Break up Big Banks!” doesn’t get us there. Big is not necessarily the problem and neither are banks by themselves. We have to keep our eyes on the prize, which is a resilient and open system that generates the credit our economy needs without creating public risk we can’t handle.

TBTF is one of many risk factors in the credit system – and far from the only one. Regulation which goes after size and nothing else doesn’t do anyone any damned good at all. We have to be a lot smarter about it than that.