Amid Washington's legislative gridlock, a desire to break up the nation's megabanks has lit a small flame of bipartisanship.

The group's right wing includes Federal Deposit Insurance Corp. director Thomas Hoenig, Federal Reserve Bank of Dallas President Richard Fisher and, most recently, conservative columnist George Will. On the left, promising a new bill on the topic co-sponsored by Sen. David Vitter (R-La), is Senator Sherrod Brown (D-Ohio) as well as economist Simon Johnson and others.  Since "bipartisan" doesn't necessarily equal "better," this unlikely alliance is based on some shaky assumptions. And the size fetish is obscuring a meaningful inquiry into the real causes of systemic risk.

Assumption 1: The failure of a TBTF firm will result in a systemic crisis.

Despite the ongoing preoccupation with the Lehman bankruptcy, no single bank failure "caused" the 2008 financial crisis. Instead, as economist Anna Schwartz noted (somewhat presciently) in 2008, the crisis was fueled by a marketwide loss of confidence in the balance sheets of many institutions, all holding similar assets – a phenomenon now called "contagion."

Now a megabank failure could pose a systemic risk, but this risk is purely operational. If the bank's core functions are disrupted, the concern is that money won't continue to flow through the system. Pre-2010 there was no coordinated liquidation process for financial "supermarkets," then subject to a variety of contradictory bankruptcy regimes.

Although Dodd-Frank's orderly liquidation provisions are imperfect, vague and likely give unconstitutional powers to the Treasury secretary, the FDIC has made great strides in developing the single point of entry recapitalization for megabanks. This allows creditors of the failed firm to be converted to equity holders at the holding company level. It wipes out existing equity holders, allowing the subsidiary operations of the bank to continue temporarily without taxpayer assistance. Temporary recapitalization addresses the moral hazard concerns that Hoenig and Fisher have raised because creditors and equity holders, who credibly believe they will be wiped out in a megabank bankruptcy, will not assume an implicit government guarantee and will tailor behavior accordingly.

Assumption 2: TBTF firms have a funding advantage over non-TBTF firms.

The pro-downsizing camp argues that firms deemed TBTF secure a funding advantage over non-TBTF firms because creditors and depositors are more willing to lend to firms that are subject to a government backstop, whether real or perceived. Proponents have also argued that this backstop results in TBTF firms securing higher ratings at the company level and on their public debt, allowing them to borrow more cheaply.

To date, the studies on this topic appear too generalized and speculative to be credible – even Senator Brown asked the GAO to investigate the claim. Additionally, if the funding advantage does exist, it is difficult, if not impossible, to discern whether it was created by an implicit government guarantee or because larger firms finance their activities more cheaply due to size, funding mix and other scale economies.  The only thing we can say for certain, as I have noted previously, is that community banks are subject to higher funding costs when compared to banks holding in excess of $10 billion, a category much broader than TBTF institutions.

Furthermore, threatening private firms with potentially destructive action is not the answer to a government-created funding advantage, if one indeed exists. That is like treating an innocuous symptom and ignoring the serious underlying disease. Prior to 2008, proponents argue, the firms now considered TBTF had no discernible funding advantage. To the extent this advantage now exists, it is a post-2008 creation based on a perceived government backstop – a self-fueling monster that came to life. 

Dodd-Frank's systemic provisions codified a problem that began with the Treasury's haphazard response to the crisis. (And using the label outside of the banking sector for firms and functions that are clearly not systemic only exacerbates it.) A credible megabank liquidation regime is just as effective in removing this perceived advantage as downsizing the firm, with fewer economic consequences.

Assumption 3: Systemic risk can be addressed at the firm level.

Systemic risk is created by the concentration of risky assets. It is a market, not a firm, issue. Unfortunately, many of the post-2008 fixes to the financial market are resulting in more, not less, asset concentration. For example, Basel III's risk-weighting rules encourage banks to concentrate holdings in the sovereign bond market. And when the bond bubble eventually bursts, this will place considerable stress on all banks, regardless of size. (Let's not forget mortgage-related products' long history of preferential regulatory and capital treatment, perhaps explaining why banks had so many of them on the books in 2007.)

Assumption 4: Reinstating Glass-Steagall will address TBTF.

Glass-Steagall cannot address size because it never was about size. The prohibition on the affiliation between commercial and investment banks was rooted in a belief that riskier underwriting and trading activities undermined traditional commercial banking. This sounds reasonable, except that if the 2008 financial crisis proved anything, it was that the more diversified the activities and assets of a bank, the better it will perform when things go wrong. And the loan origination problems at the heart of the subprime mortgage crisis suggest that making loans is just as risky an activity as trading the securities that the loans collateralize.

Assumption 5: U.S. banks are dangerously and unnecessarily large.

The U.S. produces 25% of global GDP. Yet its largest bank ranks only 9th in the world in total assets and will likely drop down the list in the coming years if China and Brazil's megabanks continue their march to supremacy. If the U.S.'s largest banks are downsized, there are plenty of foreign institutions willing to step in and fill the void. Suggesting that there are no economies of scale in banking is like arguing that Walmart has not provided cheaper products to consumers.

While smaller banks may play an important function at the local level, they simply cannot provide all the services that megabanks do and consumers will lose out. Senator Brown's concern for community banks is touching. But even community banks would argue that they are far better served by removing the crushing regulatory weight they have endured since 2008 than by breaking up the megabanks.

Oscar Wilde once noted, "Whenever people agree with me I always feel I must be wrong," a maxim Hoenig, Fisher and Will should remember before throwing their collective weight behind Brown's proposal. It's time to acknowledge that breaking up the nation's megabanks will not herald a new Golden Age where market discipline reigns supreme. TBTF is a mythical creation of our own making. The fear, at least, is real.

Louise Bennetts is associate director of financial regulation studies at the Cato Institute.