Bigger is worse

A correspondent of mine asks, apropos this story:

AIG, whose reach is so vast that the government warns letting it fail would cripple the very world financial system

Why are companies allowed to get this big? The answer is of course that they shouldn't be, if you care about financial stability and moral hazard, at least. What we need is capital requirements which are a strong increasing function of size, so that larger companies are forced to have a lower ROE than smaller ones, and hence so that they have an incentive to split. The current rules of course are the opposite: the ability to use internal models within Basel, and the advanced capital models that big insurers use, have the effect of making capital requirements lower for bigger companies. You don't need a crystal ball to figure out that that is a bad idea.