Picking up where the Dodd-Frank Act left off, Federal Reserve Bank of Minneapolis President Neel Kashkari has unveiled a new plan for ending the systemic threats of “too big to fail” financial institutions.
In 2008, TBTF banks were at the center of the financial crisis and among the triggers of the Great Recession. Subsequent regulations and reforms, particularly in the form of higher capital requirements, have indeed strengthened the financial system, he says, but “have only reduced the chance of bailout over the next 100 years from 84 percent to 67 percent.”
In February 2016, Kashkari announced a year-long initiative to explore policy solutions to address the continuing risk presented by TBTF financial institutions. Months of meetings and forums with economists, academics, and policymakers informed the proposal, “designed to reduce the risk of financial crises and bailouts to less than 10 percent, while passing a benefit and cost test.”
The Minneapolis Plan includes four steps to strengthen the financial system:
Dramatically increase common equity capital for banks with assets exceeding $250 billion. The plan requires the largest banks to issue common equity equal to 23.5 percent of risk-weighted assets, with a corresponding leverage ratio of 15 percent. This first step substantially reduces the chance of public bailouts relative to current regulations from 67 percent to 39 percent.
Call on the U.S. Treasury Secretary to certify that individual large banks are no longer systemically important or else subject those banks to extraordinary increases in capital requirements—up to 38 percent over time.
Once the new 23.5 percent capital standard has been implemented, the plan charges the Treasury Secretary with certifying that individual large banks are no longer systemically important. If the Treasury Secretary refuses to certify a large bank as no longer systemically important, that bank will automatically face increasing common equity capital requirements, an additional 5 percent of risk-weighted assets per year. The bank’s capital requirements will continue increasing either until the Treasury Department 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 to 9 percent.
Imposing a tax on the borrowings of shadow banks with assets over $50 billion. The plan levels the cost of funding between banks subject to a 23.5 percent capital requirement and shadow banks through a tax on borrowings of shadow banks larger than $50 billion of at least 1.2 percent (120 basis points). This tax rate will apply to shadow banks that are not systemically important as certified by the Treasury Secretary. A tax rate equal to 2.2 percent will apply to the shadow banks that the Treasury Secretary refuses to certify as not systemically important.
Reduce unnecessary regulatory burden on community banks. The plan allows the government to reform its current supervision and regulation of community banks to a simpler and less burdensome system while maintaining its ability to identify and address bank risk-taking that threatens solvency.
The proposal will be open for a 60-day public comment period.
“One of the key messages we repeatedly heard from experts throughout our initiative is the need to understand both costs and benefits when considering potential regulatory reforms,” Kashkari said, addressing an audience at the Economic Club of New York on Nov. 16, the day the plan was released,
He compared systemic risk in the financial markets to the trade-off of costs and benefits when combatting terrorism.
“There are costs associated with hiring additional law enforcement officers, for example, or installing more metal detectors,” he said. “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.”
The current regulatory regime and increased capital requirements have reduced the probability of a future financial crisis from 84 percent to 67 percent over the next 100 years, Kashkari said, referencing research by the International Monetary Fund. He also noted research by the Bank for International Settlements and its consensus estimate for the typical cost of a banking crisis: 158 percent of GDP, which for the U.S. economy equals roughly $28 trillion.
“Against that enormous cost, 11 percent of GDP seems to me to be a small price to pay for a modest increase in safety,” he said. ”In contrast, the Minneapolis Plan goes much further to improve safety, admittedly at an increased cost.” By his estimate, the first phase of the plan will reduce the risk of a future financial crisis and bailout to 39 percent while costs increase to 24 percent of GDP, “which is still very small compared with the typical cost of a banking crisis.” Step 2, he says, reduces the risk of a future crisis and bailout to as low as 9 percent with a total cost as high as 41 percent of GDP.
“If the Minneapolis Plan prevents one financial crisis, it will have paid for itself multiple times over,” Kashkari said. “These are the trade-offs the public needs to understand in order to assess whether we have done enough to end TBTF or if we should go further. To me, these data make it very clear that we should go much further.”