Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

While bank lobbyists and some commentators are suddenly taken with the idea that an active debate is under way about whether to limit bank size in the United States, they are wrong. The debate is over; the decision to cap the size of the largest banks has been made. All that remains is to work out the details.

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To grasp the new reality, think about the Cyprus debacle this month, the Senate budget resolution last week and Ben Bernanke’s revelation that — on too big to fail — “I agree with Elizabeth Warren 100 percent that it’s a real problem.”

Policy is rarely changed by ideas alone and, in isolation, even stunning events can sometimes have surprisingly little effect. What really moves the needle in terms of consensus among policy makers and the broader public opinion is when events combine with a new understanding of how the world works. Thanks to Senator Sherrod Brown, Democrat of Ohio; Senator Warren, Democrat of Massachusetts, and many other people who have worked hard over the last four years, we are ready to understand what finally defeated the argument that bank size does not matter: Cyprus.

There is no shortage of recrimination about how the Europeans handled the Cypriot situation. And it’s hard to feel good about a policy process that ends with the president of the Eurogroup of finance ministers, Jeroen Dijsselbloem of the Netherlands, flip-flopping on the most important issue of all: who will bear losses and in what precise order of priority, in the (likely) event of future euro-zone financial system meltdowns.

Specifically, Mr. Dijsselbloem began by making a clear statement on Monday regarding how the Cyprus situation would serve as a template for future assistance within the euro zone. After a few hours of falling stock prices for banks in peripheral Europe, he did not so much walk this statement back as sprint it back at full speed, with this remarkable retraction (provided here in its entirety):

Cyprus is a specific case with exceptional challenges which required the bail-in measures we have agreed upon yesterday.

Macroeconomic adjustment programs are tailor-made to the situation of the country concerned and no models or templates are used.

I would translate this into plain English as: “We, the combined finance ministers of Europe, have no idea what we will want to do in the future — and we have no plans to work that out before bad things actually happen.”

My colleague Jacob F. Kirkegaard, a must-read expert on European policy and its nuances, is hopeful that Europe is moving toward a variant of the Federal Deposit Insurance Corporation rules-based approach to bank resolution, in which small depositors have complete confidence they will be fully protected and other kinds of investors understand where they stand relative to potential losses (and to each other).

Contrast the chaos of the last week and Mr. Dijsselbloem’s verbal contortions with what happened when IndyMac Bancorp failed in 2008 (on the latter, I recommend Chapter 7 in Sheila Bair’s book, “Bull by the Horns”). The F.D.I.C. has very clear rules, laid out by statute and reinforced by precedent. The agency knows how to close a small or medium-scale bank without a macroeconomic soap opera — and a national catastrophe. (IndyMac had $32 billion in assets when it failed.)

But the bigger point from Cyprus is much simpler. Why would you want one or two banks to become so large in terms of their assets relative to gross domestic product that a single mistaken calculation can bring down the economy? In the American context, why would you allow any bank to outgrow the F.D.I.C.’s ability to resolve it in a relatively straightforward and low-cost manner? (The largest bank failure handled to date was that of Washington Mutual, also known as WaMu, with $307 billion in assets; JPMorgan Chase, today the world’s largest bank when measured properly, has assets closer to $4 trillion).

According to their proponents, two troubled Cypriot banks, Bank of Cyprus and Laiki Bank (also known as Cyprus Popular Bank and previously known as Marfin Popular Bank), “only” made the mistake of buying Greek government bonds, before those were restructured and fell in value, reflecting the terms of the latest euro-zone rescue package for Athens.

The third largest Cypriot bank, Hellenic Bank, also has some problems but remains out of the news for now. (For background, see this Bank of Cyprus investor presentation through September 2012 and Laiki’s third-quarter results. In both cases, these are the latest available on their Web sites.)

But this single mistake resulted in combined losses worth at least one-quarter of Cyprus’s G.D.P., not just because the bets were big relative to the balance sheets of those banks, but rather because the banks are so big relative to the economy. Banking assets in Cyprus reached seven times G.D.P., with the Bank of Cyprus having a balance sheet valued at roughly twice Cypriot G.D.P. and Laiki only slightly smaller (see the investor relations presentations linked above, with more background at Figure 3 in this paper).

And in another case study for Anat Admati and Martin Hellwig’s cautionary book, “The Bankers’ New Clothes,” the Cypriot banks had wafer-thin layers of equity, so big losses have to fall on creditors (unless taxpayers somewhere are feeling generous). For Bank of Cyprus, equity was supposedly 2.3 billion euros at the end of the third quarter of 2012, when the bank’s assets were 36.2 billion euros. I haven’t seen a convincing statement of Laiki’s recent equity funding level. The chairman of the Bank of Cyprus resigned on Tuesday, although there remains some confusion about who among the bank’s board and senior management remains on the job.

Furthermore, these banks structured their liabilities so that their only real creditors providing private-sector funding were depositors (i.e., they issued very little by way of bonds or similar forms of debt). Hence the options became either a complete bailout supported by the euro zone (making the bank creditors whole) or losses for at least some depositors.

The scale of losses in the latter route will disrupt the economy for many years and is likely to end the Cypriot offshore banking model.

Given that we have a choice, why would any American want to allow a few banks to become so vulnerable and so big relative to the economy?

Our largest banks are not yet at Cypriot scale, thank goodness. But they want to get bigger and they receive implicit government subsidies, in the form of downside protection available to creditors, which enable them to borrow more and potentially expand without limit.

In fact, it was the stated policy of former Treasury Secretary Timothy F. Geithner to encourage these banks to grow further — for example, to provide financial services to emerging markets in Asia, Latin America and Africa. This is not any kind of market outcome but rather a poorly conceived and extremely dangerous government subsidy scheme.

The good news at the end of last week was that the Senate unanimously decided that the United States should go in another direction, by ending the funding advantages of megabanks.

The decision was expressed in an amendment to the nonbinding Senate budget resolution, but this does not make it any less momentous. The vote was 99 to 0, as a result of a lot of hard work by Senators Brown and David Vitter, Republican of Louisiana, and their respective staffs. Senators Bob Corker, Republican of Tennessee, and Mark Pryor, Democrat of Arkansas, also joined this important initiative.

Lobbyists were, naturally, apoplectic.

But making last week even more decisive, Mr. Bernanke’s language shifted significantly. In a recent interaction with Senator Warren, which I wrote about in this space, Mr. Bernanke had essentially denied that large financial institutions represent a threat.

Now he has denied that denial, saying in the clearest possible terms during a news conference on March 20: “Too big to fail is not solved and gone,” adding, “It’s still here.”

And in case anyone did not fully grasp his message, Mr. Bernanke explained, “Too big to fail was a major source of the crisis, and we will not have successfully responded to the crisis if we do not address that successfully.”

Now that the policy consensus has shifted, how exactly policy plays out remains to be seen (Rob Blackwell of American Banker has some suggested scenarios).

Legislation under development by Senators Brown and Vitter will definitely be worth supporting. Opinion on Capitol Hill has now moved in a way that will continue to reinforce itself, particularly as the European disaster unfolds.

The Federal Reserve’s Board of Governors is getting the message. Even William Dudley, president of the New York Fed, a traditional bastion of Wall Street, is signaling that he now knows which way the wind is blowing.

The Orwellian doublespeak of Wall Street — nicely described by Dennis Kelleher of Better Markets — has taken a beating. Next up: cutting the subsidies of the biggest banks in a meaningful way.

Article source: http://economix.blogs.nytimes.com/2013/03/28/the-debate-on-bank-size-is-over/?partner=rss&emc=rss