Economist Paul Krugman wrote a piece Monday afternoon in which he appears to argue that it's impossible to fix the too big to fail problem, so we should just learn how to live with it. He says breaking up the banks won't help and the government swearing it won't bail any out firms doesn't work. On the surface, he's completely right. Neither of these tactics necessarily accomplishes a safer financial system. However, these options aren't entirely useless if refined. Krugman's alternative, which would cater to the systemically risky firms, is also useful to consider.
Breaking Up Firms
Krugman argues that lots of smaller firms failing isn't necessarily any better than if one big one fails. That's quite right: the economy would be approximately as much trouble if 100 financial insitutions with $20 billion balance sheets simultaneously failed as it would be if one with a $2 trillion balance sheet failed. He specifically notes the problem of bank runs here.
Yet, size does matter on some level. In particular, the second part of the so-called Volcker rule suggests that financial firms should have liability concentration limits. In other words, each institution would be limited to the amount of exposure it would have to certain types of products, firms and/or industries. While this doesn't directly call for smaller banks that would likely be the result. If lots of smaller banks develop diverse liabilities, then any one product, firm or sector won't bring it down. No single economic shock should cause a financial firm to incur losses so great that its capital base can't withstand them. (Of course, higher capital levels will also help here.)