Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don’t create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank’s stock price down.
And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets. But as decades of research in corporate finance have taught us, we shouldn’t take the second step for granted.