The Office of Financial Research looked into the question of does bank size alone tell the whole story in measuring systemic importance.  It found it isn’t the size of the bank that matters, but like all things in life how it uses its size that matters.

Specifically, the question the Office of Financial Research looked at is how interconnected is the bank with the rest of the banking system.  Is the bank so interconnected the failure of the bank triggers financial contagion and the failure of other banks.

Regular readers know transparency is the key to ending this interconnectedness and potential for financial contagion.

Why?

When banks have to disclose their current exposure details, the market can assess if each bank has more exposure to another bank than it can afford to lose.  If it does, the market exerts discipline (lower stock price and higher cost for borrowing unsecured debt) until management gets the message it needs to reduce its exposure to what it can afford to lose.

It is this discipline that ends the potential for financial contagion.  Even though the banks are still interconnected, the level of interconnectedness is reduce so the failure of any one bank does not trigger the failure of the other banks.

By the way, this also applies to large financial intermediaries like central clearing parties (for handling derivatives).