>> If a particular institution is getting too big, shouldn't the other
>> players want to hedge against its failure to protect themselves
>> against the low-probability but high-cost situation in which a
>> really big bank fails?
Evidence seems to suggest the market does not work this way. Sometimes, it appears not to work at all.
In this case as the author explains the reason they were able to grow so big is because of government involvement which through implicit and explicit measures made the risk appear artificially low.
In many cases, the problem is that if it did fail, lots of other institutions would almost certainly be wiped out.
Imagine that you open a flood insurance office right next to a levee in New Orleans. You could price things rationally, but if there's a flood you're dead anyway, so why not price your insurance low and live it up in the meantime?
Evidence seems to suggest the market does not work this way. Sometimes, it appears not to work at all.