Is the Problem the Size of Banks or Their Interconnection?

BY busadmin  February 15, 2010 at 11:03 AM EDT

Question: Is the problem the size of individual banks or their interconnection? One problem that was mentioned during the bailout was that if one bank went down, it would take the rest with it. So if the banks were smaller, would we have the same domino effect, just with a larger number of smaller dominoes? But given the scope of the mortgage meltdown, would they would still need to be bailed out?

Paul Solman: No, smaller banks would not seem to pose a domino risk: No one of them is likely to have so many contracts with other small banks that its demise would lay its fellows low.

The fear of the moment, for small U.S. banks at least, is the near and present commercial real estate crunch. Many small banks lend for local real estate development. If the developers walk away — as just happened with Manhattan’s ginormous multi-billion dollar Peter Cooper-Stuyvesant Town housing project — then small banks could be left with losses that devour their capital and put them out of business. At that point, the FDIC bails out depositors (ie, makes them whole) and generally tries to fold the banks into bigger banks.