Mega institutions (financial institutions and insurance companies come to mind) that become TOO BIG TO MANAGE are likely to become TOO BIG TO FAIL. It is impossible for top management to effectively monitor what is happening in all the nooks and crannies which have proven themselves able to bring down the largest Goliaths. And the Boards of Directors? Too friendly, to close, not independent enough, chosen as “buddies” rather than for skills needed. They have for the large part failed to perform. Chris (“I still can’t find my Countrywide mortgage documents”) Dodd’s wife serves on many boards. Her consulting company has NO clients. Just one of many many possible examples of inappropriate Board appointments.

The president of one of the largest banks (still on government guarantee life support) recently said he was ready to start growing the bank. Whoa there! The costs of “Too Big To Fail” have become abundantly clear (and they keep piling up). But what are the benefits? Are there really economies of scale or a better diversification of risk or more investment opportunities not available to smaller banks (regional banks for example)? What did shareholders and customers of these mega banks get as a payoff from their scale and scope? It is not clear what the gains might be beyond what a well run regional-size bank might produce.

Assuming my assertion is correct, there are a number of changes that the FDIC might want to consider. (1) insurance premiums could be applied to total assets since it is the quality of these assets that puts deposits at risk. Even for large banks that might fund only 25% of their assets with domestic deposits (the rest with uninsured foreign deposits and bank debt), the quality of those assets put the domestic deposits at risk; (2) insurance premiums that rise with the size of the bank, since “systemic risk” does rise with size and complexity; (3) insurance premiums that rise with the complexity of the assets (their liquidity). Complexity reduces liquidity which raises the exposure of the FDIC insurance fund to make deposits good in the event of a failure; (4) insurance premiums that rise with leverage on and off the balance sheet (maybe no off-balance sheet assets?).

If these suggested policy changes look like they might discourage the creation of huge banks with high leverage and complex financial products, you got the message. Until we can be convinced that having the “largest bank in the world” is good for the average saver, consumer and small business, smaller, better run, more customer oriented banks might better serve our economic interest. In the meantime, we need to find a way to spread out the cost of “refilling the fund” (like a line of credit from the Treasury – hey everyone else has one!). The banking system is responsible for all losses of deposits, a promise backed up by 100% of member bank equity. But it is hard for community banks to raise capital or grow organically and make more loans with the hit on earnings that has resulted from (1) a 500bp decline in the prime rate of interest, (2) increases in mandated reserves for bad debts and (3) huge increases in FDIC insurance premiums. The cost of the fund needs to be more appropriately allocated based on risk exposure (asset quality), not deposits.