Should Banks Be Allowed to Fail?

In the wake of recent financial turmoil and proposed proposed near-trillion dollar bailout, a writer by the name of Steve Maich posed the following question:

"Under what conditions would multi-billion-dollar bailouts of private businesses be acceptable? What are the criteria you’d use, if you were Paulson for deciding when it is prudent to use public money to save private business?"

In the blog entry When Should the Government Bail Out Private Companies? I responded:

"Never. The difficulty is, though, that some companies get "too big to fail" and have to be bailed out. As such what my gut tells me should happen is that, each year the U.S. Federal Trade Commission should hold hearings to determine if, in their view, any companies have become "too big to fail". If so, that company should be broken up into several smaller companies, similar to the Bell system divesture."

Is It Desirable to Provide Disincentives To Bank Expansion?

Arnold Kling of EconLog gives the following thoughtful response:

"It sounds like a good idea, BUT

The reason you want small banks is that you want them to be bite-sized when they fail, so that someone else can take them over.

But why should I take over a failed bank if the result is that next year the FTC is going to force me into divestiture because I’ve gotten too big?"

The desire to have larger banks come in and take over failing banks has an inituitive appeal given the problems of bank runs during the 1930s. If customers believe a bank will fail, they may rush out to take their money out of that bank as quickly as possible, causing even otherwise sound banks to fail.

But Is Avoiding a Bank Run at All Costs Worth It?

I do not believe it is, so I do not believe it is necessarily desirable to have large banks always take over small banks. A few reasons for this:

1. The introduction of deposit insurance has made runs on solvent banks less likely as customers know that they won't 'lose' their money if a bank goes under.
   
   
2. The increased use of electronic methods of payment such as debit and credit cards makes it such that customers are less likely to demand physical currency for their transactions.
   
   
3. One of the big drivers for innovation and economic growtn is Schumpeterian creative destruction: "Innovation by the entrepreneur, argued Schumpeter, led to gales of "creative destruction" as innovations caused old inventories, ideas, technologies, skills, and equipment to become obsolete. The question, as Schumpeter saw it, was not "how capitalism administers existing structures,... [but] how it creates and destroys them." This creative destruction, he believed, caused continuous progress and improved standards of living for everyone." By not allowing banks to occasionally 'die', you remove one of the major channels of creative destruction and thus slow economic growth.

Due to this, I am of the opinion that the occasional bank run is a small price to pay in order to prevent banks (and other companies) to become 'too big to fail'. I would love to hear your thoughts; you can leave them at this blog entry.