Too big to fail is simply too big

(MoneyWatch) COMMENTARY In my role as director of research for the BAM Advisor Alliance, I'm often asked to comment on the major economic and policy issues of the day. And one that comes up often is the issue of what to do about banks that are "too big to fail."

To begin, it's important to acknowledge that a critical feature of our banking system is the existence of FDIC insurance that protects depositors. That deposit insurance prevents runs on banks and helps avert serious financial crises, which are difficult to turn around. With banks having assets of $2 trillion or more, some banks have become too big for the U.S. government to allow them to collapse. However, providing insurance creates risks to taxpayers. And taxpayers need protection against having to bail out failed institutions.

It's also important to understand the critical role banking plays in our economy. The failure of a Bank of America (BAC) or a Morgan Stanley (MS) would have a far greater impact than would the failure of even far larger companies like Apple (AAPL) or Exxon Mobil (XOM). Banks provide the liquidity that greases the wheels of the economy. When liquidity dries up, as it did during the Lehman Brothers crisis, the economy suffers severe contractions.

So how do we provide protection against having to bail out banks at taxpayer expense? There are three ways to address the issue of protection:

• Insurance premiums charged to big banks for providing the protection to depositors
• Regulations that limit the risks banks can take
• Requirements that banks to maintain sufficient capital to act as a buffer against losses

The history of government regulation is that it never works as well as expected. Like army generals, regulators are always "fighting the last war." Entrepreneurs at banks will always find ways -- such as creating new products -- to get around regulations and take risks the regulators didn't anticipate. That leaves requiring large capital reserves as the only viable way to minimize risks to taxpayers.

So how much capital is enough? While there's no right answer, it's obvious that the larger a bank becomes, the greater the systemic risk it presents. Thus, we should require larger banks to have more capital. And while banks may not like having to add more capital, the greater their equity cushion, the cheaper the capital should be as the risk premium demanded by investors should fall. So a simple, market-oriented solution to address the issue of required capital, one that will prevent banks from becoming too big to fail, presents itself: adopt a laddered approach to capital requirements.

For example, on the first $100 billion of assets a bank would be required to have required Tier 1 capital of 6 percent. It would have to hold 7 percent on the next $100 billion, 8 percent on the next $100 billion, and so on. A bank could choose to grow larger, but the price would be that it would require proportionately larger and larger capital cushions. It's a simple and elegant solution to the problem, far better than a 2,300 page Dodd-Frank bill that no one can even read, let alone implement.

Now this doesn't rule out the need for regulations. But, as noted earlier, capital is a far better protector than regulations. With that said, restoring the Glass-Steagall Act should be a priority. Again, the price for being able to offer FDIC-insured deposits is that you will be limited in the types of risks you take. If you don't like those limitations, don't take consumer deposits.

One other thing: Moral hazard must be restored. While bank depositors must be protected, a financial institution's equity holders, debt holders and management shouldn't be. They must be allowed to fail. Capitalism, the best economic system ever developed, can't work without the possibility of failure. Knowing that you're likely to be bailed out during a crisis, leads management to take on more risks.

Photo courtesy of Flickr user The Web President