Ever since Uncle Sam pumped billions into Citigroup, Bank of America, and other banking behemoths in order to keep them alive, the question has come up: Just how big is too big, when it comes to banks?

The answer isn’t as straightforward as it might seem. Intuitively, it would seem that if a bank is too big to fail, and thus warrants the use of taxpayer money to keep it from death’s door – then, it’s simply too big. And, highly concentrated banking systems would seem more volatile than banking markets that boast more disbursed competition.

However, that’s not always the case. In a 2006 study, “Bank Concentration, Competition, and Crises: First Results,” Thorsten Beck and Asli Demirguc-Kunt of the World Bank and Ross Levine of Brown University explore this. The study appeared in the Journal of Banking and Finance. The trio examined data from banks in 69 countries, over the period 1980 to 1997. Their conclusion: Concentrated banking systems are less vulnerable to banking crises.

In addition, recent research by Celent, a consulting firm focused on the financial services industry, shows that the banking system in the U.S. remains far less concentrated than in other countries, even after the consolidation that’s taken place over the past five to ten years. Celent used what’s known as the Herfindahl-Hirschman Index (HHI) to calculate the level of market concentration. According to information from the U.S. Department of Justice, markets with HHIs between 1,000 and 1,800 points are considered moderately concentrated, and those with HHIs above 1,800 are concentrated.

The HHI of the U.S. banking market is about 400, Celent found. In contrast, the HHI of Canada’s banking market nears 2,000. Even so, Canada experienced no bank failures during the recent banking crisis, as this article in the Toronto Star points out.

Why the difference? Levine, one of the authors of the study, notes that concentration in and of itself is not strongly linked with bank fragility. The real issue, Levine says, is whether banks are too big and too interconnected to fail, or even to discipline effectively. He adds, “The profession simply does not have good measures of bank fragility or the timing of bank crises that are comparable across time and countries. So, it is difficult to draw strong conclusions about the relationship between concentration and crises.”

David Olive, the author behind the article in the Toronto Star, credits the restraint shown by Canadian banks, which refrained from loading up on subprime mortgages and other junk investments – unlike their neighbors to the south.

What is clear at this point, Levine says, is that a well-functioning financial system, which is critical to companies’ growth, is the result of all banks being able to compete on a level playing field. If banks’ size or interdependence make it impossible to get to a level playing field, it’s time for regulators to take a look. ###