Ending Too Big to Fail - Second Symposium Summary

June 10, 2016

A Summary of the Second Policy Symposium Hosted by the Federal Reserve Bank of Minneapolis on May 16, 2016

Introduction

The Federal Reserve Bank of Minneapolis kicked off its Ending Too Big to Fail initiative in February with a speech in which Bank President Neel Kashkari said that some banks are still too big to fail and that their failure would cause unacceptable damage to the American people and the economy.¹Kashkari noted that although progress has been made to address this problem, more is needed, and he announced the Bank’s initiative to present a bold and transformational solution to address TBTF once and for all.

Critical to the Minneapolis Fed’s effort to end TBTF is a series of policy symposiums designed to bring together experts with a wide range of views to discuss specific proposals. In its first symposium held April 4, participants heard proposals to require large banks to hold much more capital, to limit banks’ size and to consider the benefits and costs when developing new regulations.

The second symposium² focused on two additional transformational proposals for ending TBTF—taxing bank debt and the new framework for resolving troubled institutions. The symposium also featured a keynote on the pros and cons of reinstituting the Glass-Steagall Act. (Other approaches will be considered in future events.)

The Minneapolis Fed encourages the public not only to observe this process but to provide feedback. The Bank has established a website where anyone can share ideas for solving TBTF.³

Panel 1: Taxing leverage in the financial system

In the first panel, John H. Cochrane⁴ proposed that banks finance themselves with equity and that taxing debt would be an effective tool to achieve that goal.⁵ Here are his main points:

• Rather than bank assets, it is bank liabilities, particularly short-term debt, that are fragile and the source of potential runs. By converting bank liabilities to mostly equity, worries about runs—and the need for current levels of very costly regulation on bank assets and operations—would go away. This system would also eliminate the need for costly government bailouts.
• Unlike in the 1930s, floating-value accounts can be used for transactions: You can use your smartphone to buy a bottle of water from a machine by selling shares in an S&P 500 index fund. As a result, liquidity no longer requires fixed-value accounts (like checking accounts). Shares in 100-percent-equity-financed banks can serve as close substitutes for deposits.
• Current policies both subsidize debt (e.g., by making interest payments tax deductible) and regulate against its use (e.g., by limiting how much debt banks can have). These policies work at cross purposes. To further discourage banks from issuing the debt that is the underlying cause of instability, the government should at least stop subsidizing debt if not actually taxing it, with higher rates for short-term debt than long-term debt. The government would then have less need to use regulations.
• This plan creates substantial benefits in eliminating banking crises and has little costs. Credit supply and economic activity would not be adversely affected by the institutional change to 100 percent equity financing and the tax on debt. The new bank equity held by households would be functionally equivalent to current deposits. Households that want a risk free security could hold U.S. government debt.

Among the issues raised by the panelists⁶ and the audience were:

• The panelists agreed that leverage in the financial system, most prominently in the form of short-term debt financing of banks, was a primary driver of government bailouts.
• There was general agreement that the tax code’s subsidy to debt financing—caused by a firm’s ability to deduct interest payments when calculating taxes—encouraged financial firms to take on leverage. They noted that debt financing is favored in the tax code relative to equity financing, as firms cannot deduct payments to equity holders (e.g., dividends).
• Taxing leverage offers an advantage over other approaches because it can cover many types of financial firms that take on leverage and does not rely on government to require firms to change in very specific ways that may be excessively costly and difficult to implement effectively.
• Some panelists noted a challenge in instituting a tax on leverage both because calculating how much “leverage” a firm takes on could be difficult and because a single tax rate might end up taxing some firms too much while taxing other firms not enough. They also noted that the public may be better off banning certain practices in the private sector or regulating them rather than taxing them.
• Some panelists recommended taking a more public finance/industrial organization-based approach to financial regulation by matching the form of regulation to the nature of the externality. Sometimes the optimal level of an externality is zero (e.g., lead in gasoline). Sometimes it is better to regulate quantities, as in fisheries. Sometimes it doesn’t matter who produces the externality, as with carbon, so the tax/fee should be universal. Sometimes the adverse effects are heterogeneous, so tax rates should be firm-specific.
• A panelist noted that countries outside the United States had already taken steps to eliminate the favorable treatment of bank debt financing relative to bank equity financing following the crisis. Initial research suggests that this reform reduces leverage in a material way. Panelists also noted that structuring the charge on leverage as a fee could allow the government more flexibility in adjusting the charge as it learned from experience.
• A panelist noted that material changes in the current funding of large banks could lead to the reduction in valuable services provided by these firms, particularly if implemented over a short time frame. In particular, larger banks provide a range of services to larger customers that smaller firms cannot; these banks also are key to keeping activity going in financial markets. From this view point, fewer larger banks could potentially impede economic growth.
• A panelist noted that regulating assets is difficult, in part because there are at least two ways to measure them (generally accepted accounting principles and international financial reporting standards).
• A member of the audience pointed out that a primary goal of reform should be a system that prevents the premature and inefficient liquidation of valuable assets.

Several participants noted the positive historical relationship between financial development and economic growth and questioned what effects high capital requirements would have on growth.

Panel 1 video [YouTube]

Panel 2: Exploring alternatives to the Dodd-Frank Act’s resolution framework

In the second panel, John Bovenzi⁷ provided an assessment of the efforts to reform the resolution process for troubled banks and its role in ending TBTF.⁸ While he was optimistic about the progress made so far, he pointed out that there is still work to do. He emphasized the following:

• There needs to be an improved commitment to ending TBTF. For 25 years after the failure of Continental Illinois, not much had been done, but since the crisis lots of intellectual firepower has been devoted to it.
• Better legislative resolution regimes are helping. Titles I and II of Dodd-Frank have instigated significant advanced planning for possible resolution of large banks. Complexity is being catalogued and in some cases reduced. “Not credible” findings for the living wills of five of the eight systemically important financial institutions show the seriousness of the process.
• Better plans to implement resolution regimes are taking shape. The single point of entry (SPOE) resolution will keep operations running during a potential resolution process. At the same time, the greater reliance on long-term debt in recent proposals (rather than short-term debt) will make it easier to recapitalize a bank and avoid a taxpayer bailout.
• Automatic stays in the event of resolution will cut down on fire sales of assets.
• Finally, banks have significantly more capital and liquidity. Individual banks are less likely to fail, and contagion effects have also been reduced. Stress testing shows that the largest banks would have more capital at the end of a stress event than the entire banking system had in 2006.

He noted three important challenges going forward:

• The FDIC, the Federal Reserve and the banking industry have to continue to make progress to complete restructuring of the industry before memories of the crisis fade. Current plans have yet to be implemented.
• The FDIC and the Federal Reserve need to be clearer and more transparent about how the new resolution regime will operate; in particular, that losses will be imposed on creditors and how the lender-of-last-resort role will be implemented.
• Major structural and organizational changes are needed for large banks and the financial system.

Among the issues raised by the panelists⁹ and the audience were:

• Most panelists agreed that resolution reform was generally moving in the right direction.
• Panelists agreed that major structural and organizational change for large banks is a key and observable measure of the success of the current resolution approach. They generally agreed that forcing structural and organizational change through tools like resolution planning and higher capital requirements is superior to mandates that banks fall below a certain size threshold.
• Panelists agreed that the pace of reform must pick up.
• One panelist disagreed and did not find the current reform efforts credible. This panelist argued that government would be too concerned that imposing losses on creditors would exacerbate problems in the financial system to actually follow through on plans to do so. He was skeptical about the usefulness of resolution planning. He argued that government should focus on making it less likely that big banks get in trouble in the first place. He also argued that the U.S. economy needs large banks.
• Other panelists noted that even though they favored the general direction of the current resolution reform effort, they had concerns about its implementation along many important dimensions, including the treatment of assets in other countries, the ability of the government to act in a timely way (a comment made by almost all the panelists) and the potential that creditors will run institutions when SPOE is actually implemented.

Panel 2 Video [You Tube]

Keynote Lunch: Why I changed my mind on Glass-Steagall

Luigi Zingales¹⁰ delivered the keynote address over lunch. He discussed how his opinion of Glass-Steagall switched from opposition to support. Key points:

• At the time of its repeal, there was no strong argument to retain Glass-Steagall, and without a good reason to intervene, policy should not interfere with markets.
• While the separation of investment and commercial banking embodied in Glass-Steagall was not the best way to avoid excessive risk-taking in the financial sector, it was a good way.
• Tools such as the Volcker rule that seek to provide similar separation to Glass-Steagall are unlikely to be effective.
• Glass-Steagall was simple, and simple tools have fewer loopholes to take advantage of.
• The equity and options markets developed under Glass-Steagall are more competitive and transparent than the derivatives and over-the-counter markets that have developed since repeal.
• Glass-Steagall may have provided resiliency to the financial system: The 1987 stock market crash did not affect the banking sector, and the 1991 savings and loan crisis did not disrupt the equity market.
• The political power of banks grew after repeal. The 2005 consumer bankruptcy reform was supported by a more unified banking sector which pushed to make it more difficult to dismiss credit card debt. This may have exacerbated the financial crisis because households may have defaulted on their mortgages in order to continue servicing their credit card debts.
• The more concentrated the banking sector is, the more political power it wields. This may make it harder for new entrants (such as Fintech startups) to erode that concentration.

Keynote Video [You Tube]

Conclusion

The second symposium on ending TBTF brought a transformational option for ending TBTF and a very wide range of views on this option and a progress report on regulatory changes already in progress to a national debate. The Minneapolis Fed will continue to host symposiums exploring solutions to strengthen the economy against systemic risks presented by TBTF financial institutions. At the end of this year, these symposiums will culminate in a plan presented by the Minneapolis Fed to the public to address TBTF.

Endnotes

1 Read the full speech here.

2 See additional details here.

3 Visit the website here.

4 Senior Fellow at the Hoover Institution, Stanford University.

5 See Cochrane’s proposal here.

6 Michael Hasenstab, Executive Vice President & Chief Investment Officer at Templeton Global Macro; Michael Keen, Deputy Director of the Fiscal Affairs Department, International Monetary Fund; Donald Marron, Institute Fellow and Director of Economic Policy Initiatives at the Urban Institute; Thomas Philippon, Professor of Finance at the NYU Stern School of Business.

7 Co-chair of the Bipartisan Policy Center’s Failure Resolution Task Force.

8 See Bovenzi’s proposal here.

9 Ben S. Bernanke, Distinguished Fellow in Residence, Economic Studies, Brookings Institution and former Chairman of the Board of Governors of the Federal Reserve System and the Federal Open Market Committee from February 2006 to January 2014; J. Christopher Flowers, Managing Director and CEO of J.C. Flowers & Co.; Richard J. Herring, Jacob Safra Professor of International Banking and Professor of Finance, Wharton School, University of Pennsylvania; David A. Skeel, S. Samuel Arsht Professor of Corporate Law, University of Pennsylvania Law School.

10 Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance and Charles M. Harper Faculty Fellow, University of Chicago Booth School of Business.