Federal Reserve governor Dan Tarullo did a very interesting speech on bank regulation today that I'm still digesting. But as the Brown-Vitter bill brings new attention to the question of breaking up the largest banks, I did particularly welcome his observation that there's more to financial regulation than simply thinking about TBTF institutions:
However, note that while the presence of too-big-to-fail institutions substantially exacerbates the vulnerability created by the new system, they do not define itslimits. Even in the absence of any firm that may individually seem too big or too interconnected to be allowed to fail, the financial system can be vulnerable to contagion. An external shock to important asset classes can lead to substantial uncertainty as to underlying values, a consequent reluctance by investors to provide short-term funding to firms holding those assets, a subsequent spate of fire sales and mark-to-market losses, and the potential for an adverse feedback loop. An effective set of financial reforms must address both these related problems of too-big-to-fail and systemic vulnerability.
The point here is that you could have cascading waves of bank failure even if none of the banks was particularly large, and the risk of such a cascade would naturally raise the bailout question in just the way that a "too big to fail" bank does. The TBTF issue is like a large barnacle attached to the problem of adequate bank regulation, but it's not the problem itself. In fact if you look at it, the financial crisis has been associated with tons of failures of small banks, and even though the FDIC resolution mechanism isn't a "bailout," it raises a lot of basically similar questions about moral hazard and incentives.