The Federal Deposit Insurance Corporation says that the "too big to fail" problem is solved. Last summer's financial regulation bill gave it the power to wind down large, failing firms. It would do so by following "living wills" submitted by big banks and approved by regulators. But some market observers are skeptical, complaining that these funeral plans won't work as promised.

One such critic is columnist Allan Sloan. He doesn't believe that these living will will work out so well if a financial panic hits the market. Instead, he thinks more aggressive action should have been taken:

These "wills," which banks are discussing informally with regulators, are a weak, pathetic substitute for what Washington really should have done: that is, break up "systemically important financial institutions" into much smaller pieces. Or segregate their federally-insured-deposit parts from risky things like creating and trading derivatives.

He's saying that the living wills won't work, but breaking up the banks would have. So imagine, if you will, a world in which there were 20 firms that controlled the derivatives market, instead of just five or six. In a financial panic, all 20 see liquidity dry up, huge capital holes develop, and quickly find themselves near failure. Isn't the problem the same? The real issue here is that these firms have too much exposure to a risk and not enough capital cushion in place to prevent failure.

What might work better, instead of just breaking up banks into smaller, arbitrarily chosen parts, would be to impose limits on each type of risks that they are exposed to. That way, if a single corner of the market collapses, each bank will have enough capital to survive a panic. Of course, this would also have the side-effect of limiting the speed of growth of banks, since they couldn't just accumulate, say, many billions of dollars of mortgage loans each year as a housing bubble inflates.

So the key isn't to simply break banks up, but regulate them in such a way that they can withstand a catastrophic event hitting some segment of the market. It isn't size that matters, but the ability to endure a sufficiently ugly episode without being destroyed.

Read the full story at the Washington Post.

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