I think this problem is best understood as two simpler problems:
Imagine UberInsure bought all 10 insurance companies. Then it would be easier for them to comply with the risk requirements (it takes a more extreme event for them to fail to pay off all their obligations), but the sector is no safer than it was (or, equivalently, UberInsure can take higher profits while maintaining the same nominal risk ratio, actually increasing the risk to the sector). So capital requirements need to be weighted by company size, not just a fixed percentage.
Imagine all 10 companies invest in each other. Then although they’re nominally separate companies, they’re actually acting as UberInsure; in a crisis the correlations will go to 1 and the whole sector will collapse.
Honestly we’re already starting to address these problems, in an ad-hoc, crude way: banks that are “systemically important” are a) more tightly regulated, suggesting we’re starting to recognize at least some distinction between large and small banks b) not allowed to own each other’s paper (or rather, not allowed to count it in their assets if they do).
I think this problem is best understood as two simpler problems:
Imagine UberInsure bought all 10 insurance companies. Then it would be easier for them to comply with the risk requirements (it takes a more extreme event for them to fail to pay off all their obligations), but the sector is no safer than it was (or, equivalently, UberInsure can take higher profits while maintaining the same nominal risk ratio, actually increasing the risk to the sector). So capital requirements need to be weighted by company size, not just a fixed percentage.
Imagine all 10 companies invest in each other. Then although they’re nominally separate companies, they’re actually acting as UberInsure; in a crisis the correlations will go to 1 and the whole sector will collapse.
Honestly we’re already starting to address these problems, in an ad-hoc, crude way: banks that are “systemically important” are a) more tightly regulated, suggesting we’re starting to recognize at least some distinction between large and small banks b) not allowed to own each other’s paper (or rather, not allowed to count it in their assets if they do).