Kashkari on TBTF

Neel Kashkari, the new president of the Minneapolis Fed, is making a splash with a speech about too big to fail, and the need for a deeper and more fundamental reform than Dodd Frank.  I am delighted to hear a Federal Reserve official offering, in public, some of the kinds of thoughts that I and like-minded radicals have been offering for the last few years.

I believe the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy.

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.

From an economic point of view, now is indeed the right time -- calm before the storm. I'm not so sure now is a great time from a political view! But perhaps anti-Wall Street feelings from both parties can be harnessed to good use.

...When the technology bubble burst in 2000, it was very painful for Silicon Valley and for technology investors, but it did not represent a systemic risk to our economy. Large banks must similarly be able to make mistakes—even very big mistakes—without requiring taxpayer bailouts and without triggering widespread economic damage.

This is a key lesson. As Dodd-Frank spreads to insurance companies, equity mutual funds, and asset managers, we're losing sight of the idea that trying to stop anyone from ever losing money again is not a wise way to prevent a panic. It's the nature of bank liabilities, not their assets, that is the problem.

I learned in the crisis that determining which firms are systemically important—which are TBTF—depends on economic and financial conditions. In a strong, stable economy, the failure of a given bank might not be systemic. The economy and financial firms and markets might be able to withstand a shock from such a failure without much harm to other institutions or to families and businesses. But in a weak economy with skittish markets, policymakers will be very worried about such a bank failure.

In other words, the whole idea of designating an institution that is per se "systemic" is silly.

...there is no simple formula that defines what is systemic. I wish there were. It requires judgment from policymakers to assess conditions at the time.

Here I think Kashkari isn't really learning the lesson. If it's undefinable, even in words, and needs "judgment," then perhaps the idea really is empty.

More deeply, I think we need to apply much the same thinking to regulation that we do to monetary policy. At least in principle, most analysts think some sort of rule is a good idea for monetary policy. Pure discretion leads to volatility, moral hazard, time-inconsistency and so on. We should start talking about good rules for financial crisis management, not just ever greater power and discretion to follow whatever the "judgment" (whim?) of the moment says.

A second lesson for me from the 2008 crisis is that almost by definition, we won’t see the next crisis coming, and it won’t look like what we might be expecting. If we, or markets, recognized an imbalance in the economy, market participants would likely take action to protect themselves. When I first went to Treasury in 2006, Treasury Secretary Henry Paulson directed his staff to work with financial regulators at the Federal Reserve and the Securities and Exchange Commission to look for what might trigger the next crisis... We looked at a number of scenarios, including an individual large bank running into trouble or a hedge fund suffering large losses, among others. We didn’t consider a nationwide housing downturn. It seems so obvious now, but we didn’t see it, and we were looking. We must assume that policymakers will not foresee future crises, either.

This is an unusual and worthy expression of humility. Others advocate loading up the Fed with "macroprudential" regulation and "bubble pricking" tools, on the faith that this time, yes this time, they really will see it coming, and really will do something about it.  Regulators are not wiser, smarter, less behavioral, etc. than traders.

Speaking of the "resolution authority,"

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.

There are no atheists in foxholes, the saying goes.  Notice "forcing losses on creditors and counterparties." This is exactly right. "Bailouts" are not about saving the institution, they are about saving its creditors. We should always call them "creditor bailouts." And a run is in full swing, and when the hotlines to the Treasury are buzzing "if we lose money on this, then the world will end," anyone in charge will guarantee the debts.

I believe we must begin this work now and give serious consideration to a range of options, including the following:

• Breaking up large banks into smaller, less connected, less important entities.

Here, Kashkari caused a stir in the press. Bernie Sanders voiced approval. Since "breaking up" has no subject -- who is to do this and how? -- and no mechanism, I'll give Kashkari the benefit of the doubt that he had something more sophisticated in mind than brute force.

• Turning 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).

Aha! My favorite simple solution, more capital!  I'm delighted to hear it. Of course (to whine a bit), banks don't "hold" capital, they "issue" capital -- it's a liability not an asset. And if they have so much capital that they virtually can't fail, what is this business about public utilities? And why in the world do they need regulation akin to that of a nuclear power plant? Given how regulation has spiraled costs, stultified innovation, and stopped expansion of the one scalable carbon-free energy source we have, that's a particularly unfortunate analogy. Or maybe it's an incredibly accurate analogy for just where Dodd-Frank style regulation will lead. The point is the opposite: with "so much capital that they virtually can't fail" they don't need the hopeless project of "systemic" designation, intensive asset risk regulation, and so forth.

• Taxing leverage throughout the financial system to reduce systemic risks wherever they lie.

A Pigouvian tax on short term debt -- after we get rid of all the subsidies for it -- is my other favorite answer.

The financial sector has lobbied hard to preserve its current structure and thrown up endless objections to fundamental change.

Many of the arguments against adoption of a more transformational solution to the problem of TBTF are that the societal benefits of such financial giants somehow justify the exposure to another financial crisis. I find such arguments unpersuasive.

This needs some explanation. Banks produce studies claiming that higher capital requirements or reduced amounts of run-prone short-term funding will cause them to charge more for loans and reduce economic growth. Kashkari is pointing out that these arguments are pretty thin, because the cost of not doing it is immense -- 10 percent or so of GDP lost for nearly a decade and counting is plausible.

Obviously, I don't agree with everything in the speech. Kashkari is a bit too vague about "contagion" "linkages" and so fort for my taste. But the good news is to have this conversation, and not settle in to implementing page 35,427 of Dodd Frank regulations, head in the sand, while we wait for the next crisis.

The rest of the speech outlines his plans to get the Minneapolis Fed working hard on these issues, and to push for them at the larger Fed. This is a project worth watching.

In case I haven't plugged it about 10 times, my agenda for these issues is in Toward a Run-Free Financial System and the many blog posts under the "banking" "financial reform" and "regulation" labels.