Trying to force people to do things through code changes that punish them for not going in the 'right' direction never works in this game. Punishing small realms will only create more disgruntled and unhappy players, just like things such as the ice age and Too Much Peace did in the past.
If you want more active, engaged, realms where people interact more, it comes down to a rather simple logistics problem. Generally speaking, the more players you have in a realm, the more likely it is for the realm to have more interactions and be interesting (although this isn't always true).
But, let's assume we think big realms are good and small realms are bad (which is the main thrust of what's said here). If this is the case, the realm merger rules are sending out mixed messages. Realms can merge, but only if the end-result merged realm doesn't end up being too big. The theory being that a large merged realm could come to dominate an island. The reason this is the wrong approach is because if two realms merge to create a large realm that can dominate an island, it would then actually encourage other realms to merge to create further merged realms to rival the size of the dominant merged realm. You can't say, on the one hand, we want big realms with more players in them. But then, on the other hand, say we don't want people to create big realms through the 'wrong sized' mergers.
If you want to see an end to small realms, just allow realms to merge regardless of their existing size and then let nature take its course. Fears of all islands being dominated by two or three monolithic realms are probably unfounded because it doesn't take in to account internal conflicts creating splits. However, even if most islands did end up with (let's say) four realms, why is that a problem? As long as they're roughly equal in size, wars will still happen. Frankly, based on the current player numbers, most islands could only really sustain about 5 or 6 realms (at the very most) with a decent number of nobles in each realm. Four realms on an island with 50 nobles in each of those four realms would probably be a decent result.
Equally, if you want to reduce the number of small realms, you have to ease the pain players in those realms experience in letting them go. People become hugely emotionally attached to their realms, which is both a beautiful thing about BM, but also its curse. Again, instead of hitting small realms with penalties for being small, give them incentives to encourage them to merge. On a simple level, introduce Duchy banners so that if a small realm merges with a larger realm, they can keep the banner of their lost realm as a Duchy banner. This may just be cosmetic fluff, but most of the things about realms are cosmetic. Also, when they merge, allow them to take a certain number of recruitment centers with them to be rebuilt in the new merged realm (i.e. a Dev manually moves an existing recruitment centers in a region that's going to be lost over to a region that will be in the merged realm). Basically, allow them to take as much with them from their old realm to the new merged realm as possible. Nothing can be done about the sentimental attachments to specific locations on the maps, but things can be done to preserve other things associated with the 'vanishing' realm. Let them take everything they possibly can to the new merged realm so they feel their lost realm is just relocating and not dying.
At any rate, encouragement and incentives are the way to go. Not punishments and penalties.
