September 20, 2016
A Summary of the Third Policy Symposium within the Federal Reserve Bank of Minneapolis’ Ending Too Big to Fail (TBTF) Initiative, Co-hosted by the Peterson Institute of International Economics (PIIE) on June 10, 2016, in Washington, D.C.
The Federal Reserve Bank of Minneapolis continued its Ending TBTF initiative by gathering experts and policymakers at its third in a series of policy symposiums and the first with a co-host, PIIE in Washington, D.C.1 Underlying the effort is a belief that current reforms, while headed in the right direction, will not successfully end the excessive risk posed by TBTF banks. The Minneapolis Fed’s Ending TBTF effort, as a result, focuses on transformational solutions to fix the problem.
The first policy symposium, held in April, focused on exploring two reform proposals that would either require banks to hold much more capital than they do today or force the largest banks to break up. The second event, in May, discussed proposals to tax leverage in the financial system and to use reformed resolution schemes to end TBTF. Most recently, the third symposium took a deeper dive into the benefits and costs of higher bank capital requirements. This gathering also had a session assessing the current status of the Ending TBTF initiative, including a keynote from Minneapolis Fed President Neel Kashkari.
One defining feature of the Ending TBTF effort is public engagement. In that spirit, the Minneapolis Fed has asked the public to submit ideas to help end TBTF through the Bank’s website.2 And in an effort to conduct a transparent initiative that also serves to help educate the public, all events have been live-streamed, and public comment is welcome before delivery of the Bank’s plan by the end of the year.
A second defining feature of the Ending TBTF initiative is a focus on assessing the benefits and costs of any proposal the Minneapolis Fed puts forward. The first session of the third symposium had that precise focus with its examination of alternative frameworks to assess the benefits and costs of higher capital requirements.
Panel 1. Frameworks to assess the benefits and costs of higher capital3
The panelists raised a number of arguments with regard to assessing the benefits and costs of higher capital requirements. Their range of views also suggested several lessons for any exercise in trying to review the benefits and costs of higher capital. Key points from that session along both of those lines included but were not limited to the following:
- There are multiple ways of assessing the benefits and costs of higher capital requirements. Some methods rely largely on directly computing benefits and costs from past crisis data. Other methods analyze data through a conceptual and analytical framework (e.g., calculations based on the Modigliani-Miller theorem).
- Many methods to assess costs and benefits of higher capital estimate the benefits in terms of financial crises prevented. They make that calculation based on data from past financial crises. Many methods view the costs of higher capital as the additional costs that this requirement would impose on banks that face the new capital regime. Higher capital could be modeled as leading to higher lending costs for borrowers, for example. Some methods of benefit and cost comparison translate these higher costs for banks into general reductions in economic activity.
- Any assessment of benefits and costs of higher capital regimes is inherently uncertain. That result reflects, in part, the reliance on data from past crises to conduct the calculations. There have been a number of financial crises, but the information from those events remains limited in the context of the needs of standard statistical and economic analysis. Uncertainty also exists because no one fully understands if and how banks would try to pass on the potentially higher costs of capital.
- Assumptions used in the frameworks to assess benefits and costs are very important. Analysts should make those assumptions as clear as possible both to allow observers to know what those assumptions are and to determine how sensitive results are to the assumptions.
- Two of the panelists put forward estimates of capital requirements that they believe pass a benefit and cost test. One panelist argued that capital should be between 12 percent and 14 percent. Another found that a capital ratio of between 15 percent and 23 percent would be sufficient to avoid most government bailouts of banks in advanced economies (both estimates concern so-called risk-weighted asset capital standards).
- Both panelists noted that their estimates were higher than the standard requirements coming out of international agreements on minimum capital requirements. A third panelist emphasized the costs of these higher requirements more generally.
Panel 2: Status of efforts to end TBTF
Minneapolis Fed President Neel Kashkari opened with his remarks on the status of ending TBTF. Bertrand Badre, formerly group chief financial officer at Société Générale and Crédit Agricole, provided a private sector perspective. PIIE President Adam S. Posen assessed the global TBTF regime and international regulatory efforts. The presenters offered mostly common themes with the occasional contrasting views.
- There was broad skepticism about some of the key pillars of the current reform effort to address TBTF. In general, the presenters thought the system was too complex to work during a period of market stress.
- There was specific concern that the current reform effort required governments to impose losses on bond holders of large banks. Some of the presenters argued that this policy, if implemented, could actually lead to more uncertainty and market stress. Thus, they did not believe it would actually occur and prevent public bailouts.
- There was also concern that market forces themselves would not be sufficient to end TBTF. Market pressures may lead firms to take on too much risk, for example. As such, government has to step in to try to fix the problem.
- Some presenters focused on the complexity of large banks as a key source of the problem. The firms are too complex to manage and too complex to prevent fallout to the economy when they get in trouble.
- Some presenters noted that there is never enough capital to prevent a crisis, while others suggested that higher capital is a critical way to limit TBTF.
- Presenters suggested that the cost of higher capital, if it takes the form of lower profits for banks, could be overstated. They noted that precrisis levels of profit may have been unsustainable. As such, a fall from those levels may better reflect the true returns of banks.
- Presenters agreed that more needed to be done to address TBTF, or at least agreed that the current system was not going to be successful in that task.
- The presenters received several questions on the merits of reinstating the Glass-Steagall Act. Many of the presenters were skeptical that such a step would effectively end TBTF. They argued that the evidence from the crisis does not suggest that Glass-Steagall would have prevented the most important and negative outcomes of the most recent crisis. Many of the firms at the epicenter of the crisis, for example, did not have the combination of investment and commercial banking that Glass-Steagall prevents.
The third policy symposium raised many concerns about the current effort to address TBTF, although some participants were more concerned with the costs of the current efforts. The Minneapolis Fed will sponsor another symposium in the fall and will also ensure that the public can provide comment on its plan to end TBTF before the plan becomes final at the end of the year.