The most important economic debate of 2010 will be how to reform the financial sector to make it more stable. Many of the most popular ideas -- reducing leverage, raising capital requirements, even taxing financial transactions -- rest on the principle that smaller banks support a more stable financial sector.

I just wrote a blog post defending a bank tax that could (a) shrink large banks and (b) encourage customers to switch to smaller banks. A very smart acquaintance in finance (who asked that he remain anonymous) took issue with the underlying argument. In our reflexive hatred of Too-Big-To-Fail banks, he said, we've fetishized Too-Small-to-Survive banks. Here is a cleaned-up transcript of our (very interesting!) conversation over Gchat:

Dr. Gonzo Regarding your bank tax piece: Making the banks smaller isn't sufficient. The small banks have been a disaster as well, and a huge drain on the FDIC's funding.

We're at record levels of bank failures for small community banks. Obviously Lehman and Bear were bad things, but there have been giant costs imposed on the FDIC by small banks that people are not focusing on.

Derek: That's an interesting point.

Dr. Gonzo: The FDIC funds itself through bank assesments. So it's not necessarily the tax payer's problem. But the FDIC will prob get assistance at some point if these conditions persist.

Check out how long the 08/09 part of the FDIC bank failure list is compared to the rest. So the whole smaller = more stable thing is not really borne out by the evidence.

Derek: Are you saying bigger banks are less likely to fail?

Dr. Gonzo: I think the gist is this: Bigger means better access to capital markets and in general more diversified assets and sources of funding. So big institutions can take big hits without failing. But when they do, the costs are enormous and can be destabilizing.

Derek You're saying that the smaller = more stable equivalency is bogus.

Dr. Gonzo That's certainly what the FDIC default list suggests. Being a small community bank means you're less diversified in assets. So let's say you're a community bank in kansas. Your assets are probably all local loans. If your town has a bad property market, you're done for.

So you're not diversified on the asset side. On the funding side, honestly, I have no clue, but I doubt that some local bank in Kansas has access to the capital markets in the same manner and scope that Goldman or Merrill does. So if a small local bank needs emergency funding it's going to be tough. Goldman needs emergency funding, and they call Warren Buffet. He writes them a $5 billion check.

Derek So do you think it's misguided to fetishize the benefits of small banks? Or is yours more of a Goldilocks position. That small banks lack the larger banks' access, but there's a Too-Big-To-Fail tipping point that we want to find ways to avoid, or at least regulate much more effectively?

Dr. Gonzo Well I'm fairly agnostic in general. But I definitely think the small is better thing is pretty unfounded and runs contrary to common sense, specifically considering diversification. I mean, 2008 was all about market risk and assets hitting the floor at the same time. But just because diversification didn't work as well as it should, doesn't mean that it's not useful.

Yeah, the small bank thing is definitely fetishized, and IMHO, not based in any objective theory or evidence. It's just an aesthetic people like to cling to.

Derek: But people like Ryan Avent and Felix Salmon aren't saying: Let's regulate Goldman until it devolves into a local Kansas community bank. They're saying: There are some taxes that could a) discourage hyperaggressive betting and b) discourage banks from growing so big that the government has no choice but to bail them out.

Dr. Gonzo First off most of these "banks" are not banks. The ones on the FDIC list, those are banks. They take deposits, make loans, etc. Goldman and Merrill and so forth, they're money centers, financial intermediaries. Some of them have bank subsidiaries like Citi, but for the most part advice on transactions, broker not only ordinary securities but also funding for businesses and hedge funds, act as custodians for securities, and and in some cases, make markets by buying and selling instruments like a bookie. It is really the last three functions that make them so important to the financial system.
So in general I would recommend that we get our vocabulary straight, and then we can have a more precise conversation about what behaviors we're trying to change.