I am worried that societies and/or their governments have chosen to commit taxpayers to underwriting the solvency of banks.

Economic research has shown clear benefits to financial intermediation. The collection of savings creates a pool of funds that can be used to finance business expansion. Banking is very important to economic activity.

The United States has some enormous banks, three of them with assets of about $2 trillion each, see data and description below. They are so large, that if any one of these intuitions fails, the economy will experience a nasty financial crises and a massive recession. This is why the Fed oversees “stress-tests” for them. This is why people are talk about “privatized profits and socialized losses”.

Here is a bit more detail on the banks. The United States economy now has 7 mega-banks. Collectively these banks managed over $10 trillion in assets at the end of 2011, according to the National Information Center.1

The mega-banks are:

J.P. Morgan Chase and Company
Bank of America Corporation
Citigroup Inc.
Wells Fargo and Company
The Goldman Sachs Group Inc.
Metlife Inc.
Morgan Stanley

The first three on this list are larger than the remaining four, each with roughly $2 trillion in assets. Call them the “enormous” mega-banks. The next four each have roughly $1 trillion each in assets, and are merely mega-banks. The top 50 banking institutions in United States had a combined asset level of $14.8 trillion at the end of 2011, thus the 7 establishments listed represented two-thirds of the assets of the top 50 banks.

The economic arguments for large institutions actually come from Microeconomic Theory rather than Macroeconomic Theory. They include: natural monopoly and economies of scale.

The natural monopoly argument is not defensible. This country has been well-served by many small local banks for many decades. The small local banks know their area, their business, and their clients very well, better than a large bank possibly could. Small banks, along with the small businesses that they serve, have been instrumental to job creation.

The economies-of-scale argument is also indefensible. Research has shown that economies of scale are exhausted at a size far below these behemoths.

Worse, there are offsetting “bads” associated with extremely large banks. One problem is that banks this large have at least a bit of monopoly power, which increases the costs of banking services. A more serious problem is that banks of this size pose a risk to the economy, which is why they are considered too big to fail. Being too big to fail creates a third, insidious, problem, excessive risk taking by the large banks.

The certainty of a government bailout for these very large banks amounts to a put option. In bad states of the world, the shareholders effectively “put” the insolvent bank into the taxpayers’ hands. Options are valuable, and the value of the option increases in risk. Banks therefore, though they will deny it ferociously, assume excess risk, increasing the probability that they will fail.

The failure of a small bank is a big deal for those persons who have their deposits in that bank, it is a big deal for those businesses who borrow from that bank, and it adds to the regulatory costs incurred by the FDIC.

The failure of a bank with with total assets of $1 billion would negatively impact the area where it was located, perhaps contributing to a recession in that area. The failure of a $2 trillion dollar bank may create a recession in the United States. Given that the systematic risks dominate unsystematic risks in a financial crises that would be caused by the failure of a $2 trillion dollar bank, the probability of the failure of at least two of these institutions is quite high.

This is not all. United States banking existed just fine, worked very well indeed, for many decades without enormous banks. And, the Macroeconomic risks of their failure did not exist.

There are no good arguments for the existence of mega-banks and enormous mega-banks. However, the macroeconomic risks inherent in such large institutions are clear. And, the incentive for risky behavior on the part of an institution that is too big to fail is clear.

These enormous mega-banks are the result of bad economic policy.

1 http://www.ffiec.gov/nicpubweb/nicweb/top50form.aspx