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The Pros and Cons of Proposals to End Too Big to Fail

money-and-numbersPresident and CEO of the Federal Reserve Bank of Minneapolis Neel Kashkari said in an address in February that he did not believe that Dodd-Frank ended “Too Big to Fail” and that while progress had been made, he believes that it still would be catastrophic for the economy if the nation’s biggest banks were to become insolvent.

On Monday, Kaskhari, a former Goldman Sachs executive and a former assistant secretary of the U.S. Department of Treasury, updated an audience at the Minnesota Chamber of Commerce on the progress of the Minneapolis Fed’s initiative to end Too Big to Fail. Concerned that the status quo will lead to more taxpayer-funded bailouts similar to the ones the financial system experienced in 2008, the Minneapolis Fed is conducting a series of symposiums exploring ideas on how to end Too Big to Fail.

Kashkari said his experiences from the crisis while running the Troubled Asset Relief Program (TARP) that one of the biggest challenges the government faced was dealing with the spreading of risk between large banks.

“Multiple large banks were under stress at the same time, and actions we might have taken to recapitalize one bank (by haircutting creditors or counterparties) could actually lead to increased stress at other banks as their creditors worried they too might face losses,” Kaskhari said. “In effect, a ‘run’ at one bank could quickly become a run at multiple banks.”

In his February speech, Kaskhari outlined three possible solutions for ending Too Big to Fail that experts have cited: breaking up the large banks, substantially increasing their capital, and taxing leverage across the financial system. At the Minnesota Fed’s first Ending TBTF symposium on April 4, the first two of those solutions were explored.

While higher capital levels would help banks to better absorb economic shocks, discussants at the symposium also noted that higher levels of capital could also result in higher costs for borrowers taking out loans and that higher capital levels could encourage the migration of risk from the banking sector—which is highly regulated—to the unregulated banking sector.

Neel Kashkari

Neel Kashkari, President and CEO of the Minneapolis Fed

“As I listened to the wide range of views on the merits and costs of higher capital, it struck me that we could increase capital requirements in a straightforward way to address TBTF,” Kashkari said. “As we saw in my earlier comments about the behavior of legal structures in a crisis, there is a strong argument that simpler solutions are more likely to be effective than complex ones, so I see virtue in focusing on increasing common equity to assets, which seems the simplest and potentially the most powerful in terms of safety and soundness.”

The presenter of the “Altering the Organizational Structure of Large Banks” portion of the April 4 symposium, Professor Simon Johnson of MIT and senior fellow at the Peterson Institute for International Economics, presented the argument that large banks at the center of the U.S. financial system is a phenomenon that has come on only in the last couple of decade. Johnson also said there was little evidence that the growth of these large banks had any real benefit for the U.S. economy, an argument that Kashkari found “compelling.”

Discussants on the panel noted that having many smaller banks instead of a few large ones is not necessarily less risky for the economy, and many of them expressed doubts on how easy it would be to implement a plan to break up the large banks if such a plan were to be implemented. Discussants also pointed out that large banks benefit the economy by providing economies of scale.

“While there is a wide range of estimates of such benefits, they should lead to lower operating costs compared to relatively smaller banks,” Kashkari said. “I believe these scale arguments need to be thought of in the benefit and cost framework I mentioned before, as banks with scale may also pose significant risks to stability. But accepting it at face value, I worry that Dodd-Frank is adding to the advantage large banks have over small banks, given that complying with regulatory costs likely exhibits scale economies. We need a regulatory system that does not add to the advantage large banks have over small ones.”

Kashkari said the costs and benefits of implementing a plan to end Too Big to Fail will also be carefully considered. Questions raised by the first symposium include whether proposals to end Too Big to Fail should be viewed in isolation or combined; whether the solutions will promote fairness between the regulatory burdens borne by different-sized banks; whether or not the solutions will merely push risk into unregulated areas of financial markets; and how effective the solutions will remain over decades, among other questions.

The next symposium will be on May 16.

About Author: Seth Welborn

Seth Welborn is a Harding University graduate with a degree in English and a minor in writing. He is a contributing writer for MReport. An East Texas Native, he has studied abroad in Athens, Greece and works part-time as a photographer.

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