By Andrew A. Turner, J.D.
Delivering an update on efforts to address “too big to fail” (TBTF), Neel Kashkari, President and CEO of the Federal Bank of Minneapolis said that the advantages of substantially increasing capital requirements for the largest banks would be that banks are much better positioned to withstand unknown shocks in the future. If all of the largest banks had enough capital that investors were confident in their strength even during an economic shock, in his view, concerns about shared risks could be substantially reduced.
Kashari saw “virtue in focusing on increasing common equity to assets, which seems the simplest and potentially the most powerful in terms of safety and soundness.” Noting the need to be prepared for more change, he touted another advantage that would come from more capital—the ability to “absorb losses even from activities we cannot anticipate today.”
According to Kashkari, the Minneapolis Fed’s TBTF initiative is still in its early stages, with a series of public symposiums to be held throughout this year examining these issues. On the issue of how to deal with failing large banks, Kashkari stated that “many current reform efforts are headed in the right direction, particularly those that make banks stronger with additional capital, deeper liquidity and stress testing.”
In the past, Kashkari highlighted three options experts have offered to address systemic risks posed by large banks: breaking them up, substantially increasing capital requirements, and taxing leverage across the financial system. He also agreed that another option would be alternative resolution mechanisms that could address some of the perceived shortcomings of current resolution plans.
Current efforts. Kashkari discussed the decision by the Federal Reserve Board and Federal Deposit Insurance Corporation to deem the resolution plans of some of the largest banks in the country not credible, suggesting that the complexity, operations, and structures of these banks make their potential failure a real challenge. “We must work even harder to reduce the likelihood of large bank failures because resolving them in ways that does not trigger widespread economic harm is proving so difficult.”
One of the challenges Kashkari saw in the 2008 crisis was dealing with risk spreading between large banks. He stated that “actions we might have taken to recapitalize one bank could actually lead to increased stress at other banks as their creditors worried they too might face losses.”
Current reforms attempt to address this problem with a new legal framework combined with a plan to bring new investors into banks who agree to absorb losses when the bank gets into trouble. The idea is that by having these new investors take the hit, taxpayers will not be on the hook. According to Kashkari, this sounds good, but it has not worked in practice in prior crises, and he expressed doubt that it would work in the future. While analyzing the current regulatory framework and other potential solutions to TBTF, Kashkari concluded that it’s necessary to attempt to understand whether creditors and not taxpayers would really be allowed to take losses. He also stated that “we must work to assess whether these plans increase the transmission of risk from one bank to another.”
Costs and benefits of regulation. Kashkari emphasized the need to consider the costs of new regulations against the benefits of increased safety in our banking system. Costs include potentially lower average economic growth between financial crises. Additionally, cost increases to banks have to be passed along to customers in the form of higher borrowing costs. He provided the example of one economy with a less-regulated financial system that experiences a higher average growth rate between financial crises; but it also experiences more-frequent and more-severe financial crises than the more-regulated, slower-growth economy.
Altering bank’s organizational structure. Kashkari discussed one expert’s recommendation to impose an effective cap on bank size of 2 percent of GDP, or approximately $350 billion. He also found the argument that there is little evidence the recent growth of large banks has led to real economic benefits for the U.S. economy “compelling.”
Kashkari believes that given sufficient incentive, banks would be able to restructure themselves. He also expressed concern “that Dodd-Frank is adding to the advantage large banks have over small banks, given that complying with regulatory costs likely exhibits scale economies.”
Earlier speech. In his first speech as President and CEO of the Minneapolis Fed in February 2016, Kashkari offered his assessment of the current status and outlook for ending the problem of too big to fail banks. Since enactment of the Dodd-Frank Act, Kashkari observed, “significant progress has been made to strengthen our financial system,” but he believes that Dodd-Frank “did not go far enough” and that the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy. He further indicated that “Now is the right time for Congress to consider going further than Dodd-Frank with bold, transformational solutions to solve this problem once and for all.”
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