The discussion on the size and composition of largest of the banks got, so to say, interesting, when Sandy Weil got converted to the new ideology of small & safe banks.
However, many commentators are still singing eulogy for large universal banks, based on a mistaken 19-century understanding of how complex systems operate.
Here we attempt to show how small, functionally separated banks, with additional systems level safeguards can reduce the probability of a systemic banking crisis in most open economies.
Many of us may be familiar with the concept of firebreaks applied in forest fires. Large forest fires usually spread fast & feed on the organic material with disastrous consequences for the local environment. However, when proper firebreaks are applied, which are essentially appropriate clearing areas between two densely forested areas, and also when the size of each dense forest is reduced, the chance of a catastrophic fire is reduced to negligible levels. Similar propagation model of crisis can be applied to many systems, including the robustness of banking systems.
The results of a typical propagation model look like something shown in Chart 1 below.
Chart 1: Probability of a small event turning into catastrophe
Source: Decimal Point Analytics
The above model shows that when the proportion of interconnectedness in a system is less than about 60%, the chances of a system wide catastrophe is near zero. However, the moment interconnectedness crosses 60%, the chances of a catastrophe quickly runup to near certainty.
We had shown in one of our recent weekly reports that since the collapse of the Soviet system, the free modern world is experiencing a banking crisis every year. If we think from symptom to cause, it may lead us to believe that the banking system in modern times is too complex and too interconnected for the sake of the society it is supposed to serve.
We can reduce the complexity and interconnected in the banking system by having small, specialized banks, each concentrating on its own specialized field of operation, and with restricted regulation-limited access to interbank short-term funding market or to OTC derivatives markets. These two concepts of small banks, and small interbank market will act as a major firebreak for global the banking system.
However, given the powerful lobbies and nexuses in the real world, we are unsure if the regulators will have the courage to rock the current system.