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The more we do away with too-big-to-fail banks, the more we need CDOs and the like to provide risk and liquidity transformation.
Suppose we replace one giant, global bank with many hundreds of small banks. Each small bank will end up specialising in specific industries or geographic regions for reasons of localised economies of scale. There exists idiosyncratic risk — individual industries or geographic regions may boom or go belly up. A giant, global bank automatically diversifies away all that idiosyncratic risk and is left with only aggregate (i.e. common-to-all) risk. Individually and in the absence of CDOs and the like, idiosyncratic risk will kill off individual banks. With CDOs and their ilk, individual banks can share their idiosyncratic risk without having to merge into a single behemoth.
In the event of a true aggregate shock, the government will end up needing to bail out the financial industry no matter what the average bank size because of the too many to fail problem.
There are problems with allowing banks to become TBTF. They end up being able to raise funding at a subsidised rate and their monopoly position allows them to charge borrowers higher rates, both contributing to rent extraction which is both economically inefficient (the financial industry will attract the best and the brightest out of proportion to the economic value they contribute) and fundamentally unfair. Worse, the situation creates incentives for them to take excessive risks in their lending, leading to a greater probability of an aggregate shock actually occurring.
But we are now trying to kill off TBTF in a world in which credit derivatives have either vanished altogether or are greatly impaired. On the one hand, that reduces aggregate risk because we take away the perverse incentives offered to TBTF banks, but on the other hand, it also reduces our ability to tolerate idiosyncratic risk because we take away the last remaining means of diversification.