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Fed Bank Boss Kashkari Reignites Debate Over too Big to Fail
New Minneapolis Fed boss — and TARP boss during the George W. Bush administration — Neel Kashkari gave a blockbuster speech yesterday. Despite Dodd-Frank financial reform, Kashkari said he believes “the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy.” What’s more, he’s eventually going to present a plan to end Too Big To Fail once and for all. But not just yet.
Starting in the spring, the bank is going hold some symposiums, issue some policy briefs, gather some feedback, and then assemble a plan. But Kashkari did offer some policy options during his speech. And they’re biggies:
- Break up large banks into smaller, less connected, less important entities;
- Turn large banks into public utilities by forcing them to hold so much capital that they virtually can’t fail (with regulation akin to that of a nuclear power plant); and,
- Tax leverage throughout the financial system to reduce systemic risks wherever they lie.
Kashkari said he wants “transformational measures,” and these would seem to qualify. They have already transformed the debate, reigniting conversation about next-gen financial reform among policymakers, industry, and activists.
Just as interesting is his take on where we currently stand, post-Dodd-Frank. He outlined two scenarios. First, an individual megabank gets into trouble during a time of economic stability. Second, where one or more megabanks runs into trouble during a time of economic weakness or crisis:
My assessment of these tools under the first scenario is that they do have the potential to deal with the failure of a single large financial institution without requiring a bailout or triggering widespread economic damage. But we don’t know that for certain, and the work on these tools is incomplete and slow moving. For example, reviews of the largest banks’ living wills find that they have significant shortcomings, with the government requiring the banks to try once again to make themselves able to fail without massive fallout. Until this work is complete, which could be years from now, we must acknowledge that the largest banks are still too big to fail. And even then, we won’t know how effective these tools are until we have actually used them.
Unfortunately, I am far more skeptical that these tools will be useful to policymakers in the second scenario of a stressed economic environment. Given the massive externalities on Main Street of large bank failures in terms of lost jobs, lost income and lost wealth, no rational policymaker would risk restructuring large firms and forcing losses on creditors and counterparties using the new tools in a risky environment, let alone in a crisis environment like we experienced in 2008. They will be forced to bail out failing institutions—as we were. We were even forced to support large bank mergers, which helped stabilize the immediate crisis, but that we knew would make TBTF worse in the long term. The risks to the U.S. economy and the American people were simply too great not to do whatever we could to prevent a financial collapse.
So in the first case, he doubts the efficacy of our new financial tools. In the second, the will and efficacy our institutions.
The second scenario is particularly important to consider since it counters the “let them all go bankrupt” view on the right. That’s just not a realistic response. The goal of policy should be preventative. The idea of very large capital cushions has some appeal to me, but I will be closely watching what Kashkari and his team come up with.
Let me end with this: Believers in free enterprise and competitive capitalism need to understand the incredible damage that deep recessions and financial crises do to public confidence in markets and market-based policy solutions. That was certainly the case after the Great Depression, and so, too, the Great Recession. Just look where the energy in the Democratic and Republican parties is right now — two candidates, Bernie Sanders and Donald Trump, neither of whom seems to have much respect for economic freedom. I would hate to think what US politics will look like if we fall into another recession anytime soon.
Published in Economics
Don’t need more regulation. It can’t be done,. More capital is all that is needed, but with owner participation in all loans, and senior management with personal skin in the game. This requires clear law and fewer regulations.
Too big to fail is too big. Human nature being what it is, in a time of crisis, any CEO of a large bank/insurance company/auto company will call the Fed or the White House and pull a Cleavon Little
And politicians don’t have the nerve to say no.
The choices are either limit the size of entities so they aren’t too big, or regulate the heck out of them. I prefer size limits because the regulatory spillover on the rest of the economy would likely be significant.
Arnold Kling, who understands these things very well (econ PhD from MIT, years at Freddie Mac, excellent free market credentials), writing in National Review, has urged for years that the too big to fail banks be forced to diminish in size. A set time to reduce their footprint by whatever means they would choose (divestitures, spinoffs, etc.). There is no reason that banks cannot finance big projects as consortia rather than organically.
But there needs to be two other provisions as well. 1) Requirements that any bank that gets any kind of government bailout- direct or indirect (as when they are a creditor of a failed financial institution as Goldman was of Lehman Bros) not be paid back 100%; they need to take a hit for making bad decisions, not be subsidized by all of us. 2) Requirements that executives who lend to failing financial institutions face personal compensation clawbacks and even lose their jobs.
Will this cause some risk avoidance? Yes- but TBTF means a lot more risk for the rest of us. Good and smart leaders will still be good, smart, and successful. And there will always be ways to raise capital (e.g., “junk bonds”, etc.) that do not involve pinstripe suited aristocrats having their hands in our pockets.
Regulation makes it effectively impossible for banks to grow and innovate like any other company. Banks should not be special.
People should have the liberty to voluntarily sign away regulatory relief, and rely purely on contracts with any other party for the provision of financial goods and services.
In this way, people who feel better “protected” by the government can use the government bank. And people who want better or more creative services can contract for them, free of bureaucratic paperwork and second-guessing.
A couple of thoughts:
1) as for Neil’s second scenario, no on has adequately explained to me how smaller banks are less risky in aggregate in a crisis scenario. To the extent they are all engaging in the same types of activities, I don’t see how the risk is diminished.
2) As for preventative action, perhaps…just perhaps the prospect of not being bailed out would be a preventative measure itself.
The answer is more capital, full stop. Turning banks into regualted utilities is a fabulously bad idea.
Only works if they believe. Which elected official of the last twenty years would you believe on this?
I am familiar with some financial stuff in my corner of the United States. This area is very rural. The second-largest city in my congressional district has less than 20,000 people. There are lots of local banks throughout the area. In fact, more and more new bank names and branches seem to be popping up all the time, but they don’t seem to do any residential loan business. That all seems to be handled by about a national bank, a large regional bank, and a small regional bank. These banks always seem to be able to provide the lowest rate. Then there are mortgage companies also. I really don’t understand how the many small banks stay in business. Maybe the small banks avoid conventional loans and need some assistance through HUD, VA, and USDA. I’ve just never understood it.