Economics: How do you reform the banking industry?

Not an economist but as an observer of economic activity, here are some thoughts:

Is "too big to fail" here to stay?

Because of globalization and the size of big projects, super large banks are needed. There is still a place for your friendly small town banker for some activities but when you are financing multi-billion dollar projects with multi-national partners, you need a ginormous bank.

But the problem with "too big to fail" is that those banks will take risks because they know or think they know they will get bailed out if they get into trouble.

Is there a sweet spot where banks are big enough to conduct business on a global scale yet small enough that if one or two fail, it doesn't bring down the US or Global economy?

This item in Business Week says, let them fail and NOT letting them fail actually caused more chaos. Excerpt:

The driving premise offered is that investment banks such as Bear Stearns and commercial banks such as Bank of America (BAC), Citigroup (C), and JPMorgan Chase (JPM) are "too big to fail." I was always under the impression that capitalism was about taking risks, including the possibility of all-out failure. I thought capitalism was about reaping rewards from taking risks. Instead, the government chooses to treat market participants like consumers who continually expect that some safety net be provided for every transaction. We should allow big banks to fail because "market stability requires it."

There are two dynamics here. One is our loss of appetite for risk. When it comes to the American attitude toward risk-taking, we have lost our swagger. We have regulated risk away to the point that we are now scared to let a Bank of America or a Citigroup wind down and dissolve.

Let us not forget that there are thousands of community, regional, and national banks that could come in and buy up the deposits and performing loans of a Citigroup should it fail. The federal government erred in believing that the failure of one bank amounts to market failure.

How do regulators set capital requirements for banks?

Excerpt:

Banks hold capital as reserves to cushion the impact of unexpected losses. But many banks found ways to exploit existing capital requirements in the lead up to the financial crisis, and weren't prepared for the heavy losses that resulted from bad bets on real estate and other loans.
......
Federal Deposit Insurance Corp. Chairman Sheila Bair pushed for an international leverage ratio a few years ago but made little progress with skeptical foreign officials. The financial crisis has breathed new life into the idea. Canadian officials have pushed aggressively for it, too.

Leverage: Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.

Leverage is what banks do. People/companies deposit money in the bank expecting a return. The bank uses the deposits to lend to borrowers expecting a return to cover the return the depositors expect plus some profit for the bank which is paid to investors in the bank through dividends and increases in share price.

But if they lend too much and some of the borrowers default, they will not be able to pay back the depositors.

Thus, the challenge for the banker is:
1. how much to lend?
2. how much cash to keep on hand?

I don't know if I have the energy to read up on the current banking bill in Congress. However, this piece suggests they haven't done a good job. Excerpt:

Even Dodd's claim to shut down companies is full of holes. On page 145, the bill clearly states that the FDIC "may" liquidate and wind up a failing company. That means the FDIC "may" also decide not to.

In short, Dodd's bill wouldn't see failed firms put out of business in the next crisis, but instead produce ad hoc bailouts like those of 2008.

To function properly, capital markets need certainty about how the government will respond in crisis situations. The Dodd bill doesn't provide that clarity: Instead, it massively delegates power -- allowing regulators to decide who gets rescued and who doesn't.
............
Perhaps the greatest of Dodd's sins are ones of omission. Nowhere does his bill address the actual practice that caused the crisis: permitting widespread writing of mortgages where the borrowers had little or no equity. The Dodd bill keeps in place the same federal incentives for homebuyers to treat our housing markets as casinos.

And the only time Fannie Mae and Freddie Mac get mentioned in the bill is to continue their favored treatment. Notably, banks can still engage in proprietary trading in Fannie and Freddie securities -- even though that practice was responsible for much of Bear Stearns' catastrophic losses.

The American public has a lot to be angry about, but the spark for that rage was the bank bailouts. Yet Dodd's bill makes bailouts into permanent policy. It wouldn't bring stability to our financial system, but further erode market discipline -- while asking us to put all our faith in the same regulators who have failed repeatedly.

UPDATE: Here is a primer on the banking bill in Congress. I'll have to sift through this later ...

UPDATE: The electronic media megaphone largely gives the Democrat's point of view because they have the votes and most media is supportive of their policies anyway. But, there are some outlets for conservative views and here is a critique of the current banking bill in Congress.