Go Slow on New Bank Regulations

Ten years ago, Neel Kashkari was the Treasury department official in charge of the Troubled Asset Relief Program that bailed out the biggest U.S. banks. Now, as president of the Federal Reserve Bank of Minneapolis, he wants to make sure no such bailouts are ever needed again.

QuickTake Capital Requirements

The Minneapolis Fed’s new plan for bank regulation, released on Jan. 10, has three main pillars. Most importantly, it would dramatically increase capital requirements for large banks, and raise them even more for banks deemed to be systemically important. The plan would also impose a tax on large non-bank finance companies, commonly known as “shadow banks,” and would reduce regulation for smaller banks.

The first of these is the most important. It combines two key ideas about bank regulation that have become popular since the crisis: the idea that big banks are dangerous, and the idea that bank leverage is dangerous.

QuickTake Too Big to Fail

Sheer size can be dangerous and unfair. If some banks grow big enough to drag down large portions of corporate America in a bankruptcy, the government will have no choice but to bail them out in a crisis, as TARP did in 2008. Knowing that they’d get bailed out gives huge banks an incentive to make risky loans, since if the loans blow up it will be the taxpayer rather than the bank executives who are on the hook. That gives them a competitive advantage over smaller banks and leads to monopoly power in the banking industry.

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Leverage is dangerous because it increases risk. If the amount a bank borrows is 95 percent of the value of the assets it owns, a very small movement in the value of its assets can drive it into bankruptcy. But in good times, when a bank’s assets are going up in value, leverage increases profits. Too-big-to-fail banks are especially likely to over-borrow because of their implicit government backstop. That’s why banks tend to have higher leverage ratios than companies in other industries.

Bank leverage has fallen since 2008 as a result of new regulations and of post-crisis caution. But many economists and regulators believe that the change has not gone far enough. In their book, “The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It,” economists Anat Admati of Stanford University and Martin Hellwig of the University of Bonn suggest that a bank’s capital should consist of 20 to 25 percent of its total assets, rather than the 11.7 percent that now prevails in the U.S. John Cochrane of the Hoover Institution has even suggested barring banks from doing any sort of short-term borrowing, which would eliminate the entire bank business model.

The Minneapolis Fed’s proposal is in line with Admati’s and Hellwig’s. It’s targeted at big banks — those with more than $250 billion in assets would have to issue equity equal to 23.5 percent of their total assets, and for those that the government deems systemically important the number would rise to 38 percent.

That would make the banking system safer. How much safer is not really knowable, since it involves estimating both the likelihood and the economic impact of future financial crises. Since financial crises are rare evens, those numbers are hard to guess.

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The probability of a future crisis also depends on whether the industry figures out new ways to take on risk. Bank leverage in the U.S. has actually been falling since the 1990s — on the eve of the 2008 crisis, banks were funding themselves much more with equity than they had been in eras where no crisis occurred:

Safer and Safer

Ratio of U.S. bank equity to total assets

Source: Federal Reserve Bank of St. Louis

The 2008 crisis happened in spite of the increase in bank equity, because banks found new and riskier types of assets to invest in. Think of mortgage-backed securities and derivatives.

So while higher capital requirements increase safety, it’s not clear how high they’d need to go to prevent a 2008-style crisis. But the costs of increased capital requirements are unambiguous and immediate, since they would decrease bank revenues.

The Minneapolis Fed’s plan to loosen regulations for small banks could also end up increasing leverage at those institutions. The premise behind the plan is that big banks, with their implicit government backstop, are the main source of risk in the financial system. But in the Great Depression, small banks failed en masse — around 9,000 during the 1930s. Small banks are not immune to over-borrowing, or to panics and runs. Now, with borrowing costs for homeowners and businesses low throughout the country, there seems little need for a major deregulation of local banks.

So the Minneapolis Fed’s idea of decreasing big-bank borrowing is a good one, but it wouldn’t make the financial system immune to crises. Meanwhile, it represents short-term pain for uncertain long-term gain. Even worse, those long-term gains will be hidden from view — everyone sees a crisis that happens, but no one sees a crisis that’s successfully prevented.

Another obstacle standing in the way of the Minneapolis Fed’s plan is a fading appetite for financial regulation. The Senate is currently attempting to roll back some of the restrictions put in place in the wake of the crisis, and the House of Representatives has been pushing for even more sweeping deregulation.