The failure of Silicon Valley Bank and the reaction to that failure raise the question of what a successful banking regulatory regime looks like.

On the one hand, policy-makers want a competitive banking sector. They want lots of small banks competing for customers rather than a few big banks dominating. You hear this in the laments over the decline in community banks and efforts to rejuvenate them.

On the other hand, policy-makers want every bank to succeed. The problem is that bigger banks are generally more stable than smaller banks. Silicon Valley Bank’s being constantly referred to in media reports as the 16th largest bank in the country makes it sound bigger than it was. In fact, despite the stated desire from policy-makers to have more competition, the banking industry has consolidated more since 2008, with the top four banks (JPMorgan Chase, Bank of America, Citibank, and Wells Fargo) dwarfing everyone else. There’s a second tier of moderately large banks (such as PNC, U.S. Bank, and Truist), then there’s the third tier that included Silicon Valley Bank — above small community banks but nonetheless regional and tiny compared to the top four.

Silicon Valley Bank’s strength was its specialization in tech start-ups, but the dark side of that strength was the lack of diversification. That’s a problem that is much harder for a giant national bank to have. If Citibank has a problem with one type of customer, it has a thousand other types of customers it can still work with. If Silicon Valley Bank has a problem with its only type of customer, it fails.

Bank failure does not have to mean anyone loses their deposits, though, and not only because the FDIC insures them up to $250,000. If another private bank buys out a failed bank, its depositors can make out just fine. But regulators make it more difficult for banks to merge, out of fears of their becoming too big. They also frequently treat bank failure as an extremely serious event. When other types of businesses go under, it’s seen as part of the cyclical nature of a dynamic economy.

If we want a competitive banking sector, we can’t treat smaller bank failures as extinction-level events. In competitive sectors of the economy, businesses go under all the time. Competition should reward what works and punish what doesn’t.

If we want every bank to be rock-solid, we need to get comfortable with big banks. Big banks aren’t only “too big to fail” from a macroeconomic standpoint. It is genuinely harder for them to fail since they are more diversified than small banks and less dependent on particular regional economic conditions that fluctuate outside anyone’s control. At the same time, being too big to fail must have regulatory consequences that will entrench incumbents and inhibit innovation.

I’d prefer competition, but that is not the direction U.S. regulatory policy has gone since 2008. Dodd-Frank has made the big banks bigger and continued to treat bank failures as something to be avoided per se. Competition need not mean macro-instability, even though it would mean more turnover at the firm level. One way to use market discipline to keep banks honest is contingent convertible bonds.

Arnold Kling describes how they would work:

The idea was to have banks issue long-term bonds that convert to equity when the bank’s capital falls below some minimum level on a market value basis. When the bonds convert, the shareholders lose most of their stake, and the bondholders own most of whatever is left. The depositors lose nothing, because the restructured bank is solvent.

The holders of contingent convertible bonds will want to insert controls, known as covenants, to make sure that the company’s management takes only prudent risks. Not wanting to end up becoming owners of a troubled bank, the convertible bondholders will act like regulators.

That would better align incentives and could work for small and large banks alike. It at least seems worth a try.

Until we change the way we regulate, expect big banks to keep getting bigger — and don’t expect any of the people who cry out against big banks to understand that their preferred regulatory regime is causing the behemoths’ growth.