Fed's Kashkari Releases Plan To End "Too Big To Fail", Compares Banks To Terrorists

In the latest reminder that 7 years after the financial crisis, the US banking system still remains a systemic risk, Minneapolis Fed President Neel Kashkari today released four-step plan to end too-big-to-fail problem. In his speech to the economic club of New York, the former Goldman banker said that while significant progress has been made to strengthen U.S. financial system, biggest banks continue to pose a significant, ongoing risk to our economy.

Under the “Minneapolis Plan,” there would be “fewer mega banks,” community banks would thrive, and mid-sized banks would make up larger share of system.

A summary of the proposed Fed plan argues that large banks already under shareholder pressure to reorganize will face increased pressure to consider breaking themselves up.

  • The plan, which will naturally be ignored by the banks themselves and the authorities, is culmination of efforts since February that brought together experts on financial crises and bank regulation, such as former Fed Chairman Ben Bernanke and ex-central bankers Roger Ferguson and Randall Kroszner according to Bloomberg.
  • Largest banks “refused to participate” for fear their presence would be viewed as acknowledgment that TBTF problem exists.

The first two steps would be to increase capital requirements for banks with assets of more than $250b to 23.5% of risk- weighted assets, and to have Treasury secretary either certify that large banks are no longer systemically important or subject those institutions to increases in capital requirements of as much as 38% over time. Additionally, the minneapolis Fed plan would only count common equity as capital.

The threat of massive increases in capital will provide strong incentives for largest banks to restructure so that they are no longer systemically important. The proposed approach is similar to those regulators have taken with nuclear power plants, imposing such tight restrictions so as to minimize risk of failure.

The other two steps would be to impose tax on borrowings of shadow banks with assets over $50b, and reducing regulatory burden on community banks.

Kashkari defended his plan by saying that most companies outside financial services industry have much bigger buffers than banks. Under his plan, which requires bigger buffers, “some banks would probably have business models that don’t work. They probably already have business models that don’t work,” he says, adding: “That’s not our problem.”

It is however, the banks' problem, and is another reason why the plan will be soundly ignored. "My hope is that there’s interest on both sides of the aisle for this type of work and analysis." Wrong.

Undeterred, Kashkari went on to say that his plan “would require legislation” and in case there was confusion, he said that “what we are proposing is a major restructuring of our financial sector."

Too bad such a "restructuring" will not take place until after the next crisis.

The plan's four proposed steps are the following:

Step 1. Dramatically increase common equity capital, substantially reducing the chance of bailouts

 

We will require covered banks to issue common equity equal to 23.5 percent of risk-weighted assets, with a corresponding leverage ratio of 15 percent. This level of capital nearly maximizes the net benefits to society from higher capital levels. This first step substantially reduces the chance of public bailouts relative to current regulations from 67 percent to 39 percent. This substantial improvement in safety comes at a relatively low cost of gross domestic product (GDP). Covered banks will have five years to come into compliance with this requirement

 

Step 2. Call on the U.S. Treasury Secretary to certify that covered banks are no longer systemically important, or else subject those banks to extraordinary increases in capital requirements, leading many to fundamentally restructure themselves

 

Once the new 23.5 percent capital standard has been implemented, we will call on the Treasury Secretary to certify that each covered bank is no longer systemically important. Our proposal gives the Treasury Secretary the discretion to make this determination so that it can rely on the best information and analysis available. We suggest that the Treasury start by reviewing existing metrics of systemic risk used to determine current GSIB surcharges. The Treasury will also have the authority to look beyond covered banks in making its determination. If the Treasury refuses to certify that a covered bank is no longer systemically important, that bank will automatically face increasing common equity capital requirements, an additional 5 percent of risk-weighted assets per year. This process will begin five years after enactment of the Minneapolis Plan. The bank’s capital requirements will continue increasing either until the Treasury certifies it as no longer systemically important or until the bank’s capital reaches 38 percent, the level of capital that reduces the 100-year chance of a crisis below 10 percent.

 

Step 2 is a critical step for ending TBTF. Under the current regulatory structure, there is no explicit timeline for ending TBTF, and regulators never have to formally certify that large banks and shadow banks are no longer systemically important. Instead, banks and designated nonbank financial firms can continue to operate under their explicit or implicit status as TBTF institutions potentially indefinitely. The Minneapolis Plan reverses this approach and gives the Treasury Secretary a new mandate with a hard deadline. Five years after enactment of the Minneapolis Plan, the Treasury either will certify that large banks are no longer systemically important or those banks will face extraordinary increases in equity capital requirements.

 

We believe that these automatic increases in capital requirements will lead banks to restructure themselves such that their failure will not pose the spillovers that they do today and lead to future bailouts. We chose the capital level that reduces the probability of a bailout in Organisation for Economic Co-operation and Development (OECD) countries to 10 percent or below while keeping total costs below benefits. This level of capital is appropriate for the largest banks that remain systemically important, as their failure alone could bring down the banking system.

 

The only banks that could remain systemically important after the Minneapolis Plan has been fully implemented would have 38 percent common equity capital, with a risk of failure that is exceptionally low. This is a similar approach regulators have taken with nuclear power plants: While not risk free, they are so highly regulated that the risks of failure are effectively minimized. Step 2 of the Minneapolis Plan reduces the chance of future bailouts to 9 percent over 100 years.

 

Step 3. Prevent future TBTF problems in the shadow financial sector through a shadow banking tax on leverage

 

We discourage the movement of activity from the banking to shadow banking sector by levying a shadow bank tax. The tax equalizes the funding costs between the two sectors. The tax will have two rates. To equalize funding costs with a 23.5 minimum equity requirement, we would levy a tax on shadow bank borrowing of 1.2 percent. This tax rate would apply to shadow banks that do not pose systemic risk as judged by the Treasury Secretary. A tax rate equal to 2.2 percent would apply to the shadow banks that the Treasury refuses to certify as not systemically important. Thus, the shadow bank tax regime mirrors our two-tier capital regime. These taxes should reduce the incentive to move banking activity from highly capitalized large banks to less-regulated firms that are not subject to such stringent capital requirements. Nonbank financial firms that fund their activities with equity do not pay the tax. Shadow banks will have five years from enactment of the Minneapolis Plan before they begin paying the shadow bank tax. The Treasury Secretary will start making certifications as to the systemic importance of shadow banks at that point. Here, too, we grant the Treasury discretion to look across all nonbank financial firms in its certification process.

 

Step 4. Reduce unnecessary regulatory burden on community banks

 

Ending TBTF means creating a regulatory system that maximizes the benefits from supervision and regulation while minimizing the costs. The final step of the Minneapolis Plan would allow the government to reform its current supervision and regulation of community banks to a system that is simpler and less burdensome while maintaining its ability to identify and address bank risk-taking that threatens solvency.

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One interesting section lays out the MN Fed's calculation of a probability of bailout in the next 100 years:

Alongside this, Kashkari lays out not only the change of a bailout in the next 100 years, but the overall cost of this as a percentage of GDP.

We have developed a framework for assessing safety and costs. The first column says “Chance of a Bailout in the Next 100 Years.” The IMF has compiled a database of financial crises around the world that we use to assess how frequently financial crises have happened in the past and what regulations were in place when those crises happened. Fortunately, financial crises are infrequent events, but that makes them hard to predict, like terrorist events or earthquakes. This IMF database contains the best data available to look at the history of financial crises and make informed estimates about their future likelihood. We look at a 100-year time horizon because the Great Depression took place in the 1930s and the recent financial crisis in 2008, approximately 80 years later. Aiming to prevent financial crises over a 100-year time horizon seems like a reasonable goal, given how devastating crises are when they hit.

 

On the right side of the table, we list costs. Here we calculate the present value of future costs, using a similar method as do regulators around the world.

 

We set as a baseline the capital regulations that existed in 2007, before the onset of the recent financial crisis. An examination of the IMF database of crises and the regulations that existed in 2007 implies an 84 percent chance of a crisis in the following 100 years. Obviously, the crisis in fact happened the next year. The database offers a view of how likely crises are to happen, not when exactly they will happen. In terms of costs, we set the 2007 regulations as a baseline, so we assume those costs are zero for comparison purposes.

 

Next we look at the current capital regulations, which have increased capital requirements relative to 2007. As you can see from the table, the probability of a future financial crisis has been reduced, from 84 percent to 67 percent over the next 100 years. That is a modest improvement in safety at a cost of 11 percent of GDP. Is 11 percent of GDP a lot or a little?

 

Here we see that the Bank for International Settlements’ consensus estimate for the typical cost of a banking crisis is 158 percent of GDP, which for the U.S. economy equals roughly $28 trillion. This is the present value of the long-term effects of a banking crisis. As we have seen since the recent crisis, the U.S. economy has been growing much more slowly than had been previously expected. These long-term effects are fairly typical for financial crises, which as you can see, are extraordinarily costly for society. Against that enormous cost, 11 percent of GDP seems to me to be a small price to pay for a modest increase in safety.

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Ultimately, the goal of Minneapolis Plan is to "educate public and elected representatives about options." Amusingly, in doing so Kashkari ends up comparing American banks to terrorists:

One useful analogy that helps highlight the trade-off of costs and benefits is the risk of terrorism. Intuitively, the public understands that we as a society cannot eliminate all risk of a future terrorist attack. It is simply impossible to make that risk zero. And the public intuitively understands that increased physical safety isn’t free. There are costs associated with hiring additional law enforcement officers, for example, or installing more metal detectors. Since we cannot eliminate all risk, we have to decide how much safety we want and what price we are willing to pay for that safety. The same is true for financial crises. We cannot make the risk zero, and safety isn’t free. Regulations can make the financial system safer, but they come with costs of potentially slower economic growth. Ultimately, the public has to decide how much safety they want in order to protect society from future financial crises and what price they are willing to pay for that safety.

An apt analogy, if perhaps not one the banks will be particularly delighted with.

Kashkari's full speech can be found here, while readers can access the full 53 page plan at the following URL.

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