How to avoid financial crisis in the future? Decrease the number of banks

So the Fed finally decided to help AIG out. It’s true, as I pointed out in my last post, AIG, an insurance firm not under the regulatory jurisdiction of the Fed - is too big to fail. The Fed had no choice but to come to the rescue.

Unfortunately, nowadays, we do have an abundance of globally inter-linked institutions that are now too big to fail. And they are all prime candidates for a government bailout should any of them end up with unlucky trades. Theoretically, we could have an endless line of institutions who can “privatize profits but socialize failure”.

So what’s a regulator to do?

The Fed need not end up regulating all “non-bank” financial institutions that come into existence. That will only end up giving the Fed responsibility for their viability as ongoing concerns. What the Fed needs to do is to come up with a more stringent framework for regulating the largest counterparty transactions of those institutions that do come under its umbrella – the banks.

Unfortunately, that can amount to endless reams of transactions to review for each bank under the Fed’s purview.

A possible solution? Decrease the number of banks. This lessens the network effects of a larger population of banks inter-dealing with one another. That might still leave us with fewer banks that get to grow even bigger, and definitely too big to fail. But at least, among these few, the level of regulatory scrutiny can be deeper.

Think about it. Less banks. Less unbridled greed. Less destructive maneuvering for profit. Less to bail out. But greater oversight over the few.

Hedge funds and independent broker-dealers can go on being unregulated. But if they enter into a significant transaction with a regulated bank as the other party, the Fed can and will know all the details.

Mr. Bernanke, what about incentivizing more consolidation?

Update: As of mid November, I may have changed my mind.