But isn’t this scenario impractical for reasons shown by the current problems in Europe? On Cyprus, the banks were considered “too big to fail”, meaning that they would take the whole economy with them if they went down.
Cyprus is not a good case study - the banks there actually are the whole economy, to some degree. Aside from tourism, they were supporting themselves by banking a lot the money coming of Russia, etc. The assets of Cypriot banks were ~9X their GDP, and the size of the estimated bailout was about 1X GDP.
If you don't let big banks fail, then nobody ever has to worry about counterparty risk, and they won't keep an eye on each other to see if one bank is taking too much risk or backing too many bets.
