Appendix B: Ending TBTF Initiative Process
- Section 1: Summary of the Minneapolis Plan to End Too Big To Fail
- Section 2: Recommendations: Key Support and Motivation
- Section 3: General Empirical Approach for the Capital and Leverage Tax Recommendations
- Section 4. Technical Calculations for the Capital and Leverage Tax Recommendations
- Section 5: The Banking and Financial System Post-Proposal Implementation
- Appendix A: The Leverage Ratio in the Minneapolis Plan
- Appendix B: Ending TBTF Initiative Process
Building upon the Federal Reserve Bank of Minneapolis’ expertise in the area of Too Big to Fail (TBTF), President Neel Kashkari used his first public speech in February 2016 at the Brookings Institution in Washington, D.C., to launch an initiative aimed at addressing excessive risk posed by TBTF financial institutions.49 In his announcement, Kashkari committed to considering a broad range of policy solutions and putting forth a draft Minneapolis Plan by the end of 2016 for legislators, policymakers, and the public to consider.
The first phase of the initiative was rooted in hosting four policy symposiums based upon rigorous exploration and discourse, starting out with broad topics and then revisiting promising ideas with sharper analysis. From the outset, Kashkari pledged that the Ending TBTF initiative would be open and accessible to all. The dual goal of this transparent approach was to explore and analyze substantive solutions through the gathering of economists, policymakers, and other issue-area experts, while also educating the public about TBTF issues through open public forums. In this spirit of open and public discourse, all symposiums and public events within the Ending TBTF initiative were live-streamed and archived on the Minneapolis Fed website.50 The public has also been encouraged to interact by engaging through social media using the hashtag #EndingTBTF or submitting their input and ideas online.51
Upon publication of the draft Minneapolis Plan in November 2016, the second phase of the initiative commenced with a two-month public comment period that welcomed feedback and constructive input. The feedback received during this period became the basis of the response document that details the comments received and the revisions made to the November 2016 draft Plan. In addition to revising the draft Plan, the Minneapolis Fed continued its effort to educate the public about the continuing risk of Too Big to Fail through speaking engagements and written pieces published as traditional newspaper op-eds and online postings.
Appended below is a presentation of:
- Summaries of the four policy symposiums in the Ending TBTF initiative,
- A Request for Comments on the draft Minneapolis Plan, including a 60-day open comment period and a list of specific questions aimed at inviting feedback on particular elements of the draft Plan.
- Commentary about Too Big to Fail that President Kashkari published after release of the draft Plan, and descriptions of public engagements organized to educate the public on the process and substance of the Ending TBTF initiative.
First Ending TBTF Policy Symposium, April 4, 2016
The first symposium focused on two specific transformational proposals for ending TBTF—higher capital requirements and limits on bank size—and featured a keynote address by a former Federal Reserve governor, who discussed the appropriate role of weighing both costs and benefits in financial regulation.52
Panel 1: Substantially increasing capital requirements
In the first panel, Anat Admati53 proposed that banks substantially increase their equity to as much as 30 percent, a level comparable to nonbanks. More equity means banks can absorb greater losses on their assets before they become insolvent. Here are her main points:
- The failure of systemically important banks generates significant harm to society that banks do not consider when they decide to grow or take on risks. Higher capital requirements would reduce risk of harm.
- Large banks are very risky institutions—they are opaque and complex, making orderly resolution difficult. Passing a stress test is no guarantee of even medium-term solvency. Society is better off trying to prevent their failure than trying to make their failure “safe.”
- Even under Dodd-Frank Act regulation, capital ratios continue to be tiny, on the order of 4 percent. Moreover, these capital figures are misleading because they rely a great deal on complex accounting done by the banks. Leading up to the failure of Lehman Brothers in 2008, banks that later failed had about the same, if not slightly higher, capital ratios than banks that did not fail.
- Moreover, regulatory capital requirements have been shown in many cases to be poorly designed. For example, sovereign debt held by European banks was considered risk-free (and required no capital be held against it), but turned out to be quite risky.
- Banks argue that they cannot operate with higher capital requirements, because it would be too costly and would reduce their ability to provide loans. But compared with nonbank firms, banks have much less capital and are much more likely to make regular payouts to shareholders. Both have risky, long-term, illiquid assets and can use retained earnings (or new shares) to grow. But nonbanks typically have at least 30 percent equity funding (and often more) as a share of assets and often go long periods of time without making payouts to shareholders. Banks, however, rarely have as much as 6 percent of assets funded by equity and typically make payouts to shareholders unless they fail a stress test.
- Current plans to make banks more able to absorb losses would allow banks to issue debt that converts to equity and count that debt as a buffer to absorb losses. That debt approach is largely untested, but experience with it so far suggests that it will not work. Issuing more equity would be more straightforward and effective.
The views of the panel54ranged from support for higher capital requirements to opposition:
- Supporters highlighted analysis suggesting that the benefits of increasing capital (to up to two times the current requirements) exceed the costs. They also pointed out the simplicity of higher capital requirements compared with the current system, and argued that the current approach is too complex and will not work in practice.
- Other panelists noted that it was difficult to determine how much capital banks should hold. They argued that measurement of the implied government support that firms might get is needed to set capital requirements, tax rates or premiums to encourage banks to curtail risks.
- Still other panelists argued that current approaches will work. They noted that current capital stress tests are precisely about ensuring that banks do not fail in a bad state of the world. Banks have a lot more capital now than in 2008, and the stress tests have gotten harder since the first one in 2009. They also argued that the costs of capital were real and that higher capital would lead to lower economic activity.
Panel 2: Altering the organizational structure of financial institutions
In the second panel, Simon Johnson55 proposed that the size of banks, as measured by “total exposure” reported to the Federal Reserve System, be capped at 2 percent of GDP, or about $350 billion. For institutions with exposures above this threshold, he proposed imposing stringent capital requirements. He defended his 2 percent threshold by noting that:
- Lehman Brothers had assets in excess of $600 billion when it failed in September 2008, and Bear Stearns had assets of nearly $400 billion when it was saved. In contrast, smaller firms, such as CIT Group (about $120 billion in total exposures) were allowed to fail without causing damage to the broader financial system. If all banks were small enough, they could fail without the need for bailouts or large costs for society.
- The size cap would impact the following 10 banks, listed here with total exposure in 2014: JP Morgan Chase ($3.7 trillion); Bank of America ($2.8 trillion); Citigroup ($2.8 trillion); Wells Fargo ($2.2 trillion); Goldman Sachs ($1.5 trillion); Morgan Stanley ($1.3 trillion); US Bancorp ($539 billion); PNC ($460 billion); Bank of New York Mellon ($418 billion); and HSBC North America ($417 billion). The framework for resolution of large, complex financial firms is clearer now than in 2008, but there are still substantial residual risks associated with resolving these firms, especially regarding their global footprints.
- Measured in terms of shareholder equity divided by total exposure, bank capital is still quite low even after the post-crisis regulatory changes. Firms could still fail in the event of a large adverse shock.
- Some risk-taking by large banks has been limited by the Volcker rule and other provisions of the Dodd-Frank Act, but the performance of these provisions under stress remains untested.
- These regulations could be implemented under existing legislation.
- Stringent capital requirements for banks above the threshold would lead boards of directors and management to reorganize and break up their firms.
- Large banks are a relatively recent phenomenon, and there is no evidence that their rapid growth over the past two decades has enhanced growth of the U.S. economy. However, the size and willingness of large financial institutions to take on bigger risks did contribute to the severity of the crisis in 2008.
Among the issues raised by the panelists56 and the audience were:
- Large nonfinancial firms, especially multinationals, have banking needs that may be best served by large banks.
- After controlling for risk-taking, analysis suggests significant scale economies in banking, especially for the largest banks. A 2 percent size limit would forfeit these economies.
- A size cap would mean millions of Americans would need to change their banks. Retail customers seem to prefer big banks.
- Breaking up banks into smaller pieces would be difficult and could have unintended consequences, including loss of access for less-profitable customers.
- Banks are prohibited from having a single large equity stakeholder who would have the incentive to provide adequate monitoring. Eliminating this distortion is important, but a size cap would not address it.
- Past financial crises, such as the Great Depression, were not related to the size of banks.
- Part of the reason some banks got so big is that they acquired troubled smaller banks, including during the last financial crisis.
Keynote Lunch: The need to consider both costs and benefits while assessing bank regulations and in addressing sources of financial fragility
- Former Federal Reserve Governor Randall Kroszner57 delivered the keynote address over lunch. He discussed the importance of conducting careful examinations that consider both costs and benefits of various bank regulations, while warning against allowing “analysis paralysis” to prevent regulators from acting. Key points:
- Good policy regulation involves several steps: diagnosing the problem via theoretical and empirical analysis; considering both costs and benefits before choosing an action from a set of reasonable alternatives; acting; reviewing the effects after a period of time, say five years, while continuing to refine the options.
- As part of the review process, questions to ask include: Did we achieve our goals? Have there been any unintended consequences? Again, data are needed to answer these questions. The Office of Financial Research is working to collect new data with this in mind.
- Financial institutions exhibit three fragilities: leverage, liquidity and interconnectedness.
- Elected officials must provide guidance regarding how safe a financial system we want. There is a trade-off between safety and growth.
- We do not want to rely too much on any one particular form of regulation.
- Use historical and international comparisons to inform comparisons of costs and benefits.
- Kroszner also agreed that debt that converts to equity may not work in practice when a crisis develops.
Second Ending TBTF Policy Symposium, May 16, 2016
The second symposium 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.58
Panel 1: Taxing leverage in the financial system
- 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 panelists61 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 2: Exploring alternatives to the Dodd-Frank Act’s resolution framework
In the second panel, John Bovenzi62 provided an assessment of the efforts to reform the resolution process for troubled banks and its role in ending TBTF.63 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 panelists64 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.
Keynote Lunch: Why I changed my mind on Glass-Steagall
Luigi Zingales65 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.
Third Ending TBTF Policy Symposium, June 20, 2016
Co-hosted with the Peterson Institute for International Economics (PIIE), Washington, D.C.
The Ending TBTF initiative continued 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.66 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.
Panel 1: Frameworks to assess the benefits and costs of higher capital 67
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 ratios 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.
Fourth Ending TBTF Policy Symposium, September 26, 2016
The fourth and final symposium hosted by the Federal Reserve Bank of Minneapolis was held on September 26, 2016. Progressing toward the goal of releasing a policy plan to end too big to fail (TBTF) by the end of the year, the symposium explored additional challenges and solutions to the persistent problem of TBTF.
Two panel discussions were held, the first focusing on whether debt issued by banks—such as “bail in” bonds required under a current Board of Governors proposal—can effectively recapitalize banks in the resolution process. The second panel discussed the growth of the shadow banking industry in response to the asymmetrical regulatory framework of banks and nonbanks.
This fourth symposium also featured a keynote speech by Roger W. Ferguson, Jr., who shared views on financial regulation based on both his current role as president and CEO of TIAA and his prior role as governor and vice chair of the Board of Governors of the Federal Reserve System.
Panel 1: Converting debt to equity as a means to address TBTF
The panelists,68 coming from a wide range of backgrounds and perspectives, made key points, which include but are not limited to the following:
- Bank equity is the best tool to absorb losses because shareholders absorb losses from insolvency.
- Panelists noted the challenge of converting debt to absorb losses from bank failure. In general, panelists noted that supervisors have not done a good job of forcing banks to get new capital before they suffer deep losses, at which point it is difficult to recapitalize the bank without public funds.
- This general problem is present in the so-called total loss-absorbing capacity proposal, which counts on government taking unpopular action at an ill-defined point. Thus, some panelists thought that TLAC has been vastly oversold as a solution to TBTF.
- An alternative view presented is that the provision of a resolution regime, combined with some debt to convert to equity, does make it less likely that firm creditors get bailouts and thus does address TBTF.
- The political pressure against acting will be very large if the perception is such that action can lead to more instability.
- The panel discussion also suggested that requiring government to shut down banks when equity is still positive would be a move to forcing more timely action.
Roger W. Ferguson, Jr., Keynote: Financial regulation from the viewpoint of the regulated
Roger W. Ferguson, Jr.,69 began his remarks by commending the work of the TBTF symposium series for its exploration of resiliency in the broader financial system. He went on to note that these discussions usually look at regulations from the view of the regulator; but from his post-2008 experience after leaving the Federal Reserve System, Ferguson shared his current perspective of leading TIAA, a regulated insurance institution.
- Ferguson analyzes regulations through a prism of an organization predominantly engaged in insurance. From this viewpoint, he emphasizes the importance of exercising restraint in imposing bank-centric frameworks upon nonbanks. Rather, regulators should recognize that insurance-centric firms have a different business model, structure, and role than banks.
- The primary policy goal is to ensure that there is a resilient financial system to stress. Financial resilience should be achieved by having an ecosystem that is not monolithic, but has many different components that serve to maintain the “diversity of the financial eco-system.”
- Of course, the system needs to be safe and sound. Additionally, it needs to minimize the creation and propagation of spillovers.
- To achieve the overarching goal of financial resilience, the TBTF problem must be addressed though a nuanced approach that recognizes the differences in various institutions and does not treat them with a one-size-fits-all approach.
- Ferguson emphasized this as his primary point, noting that an approach that treats all firms in a monolithic fashion could end up making the system less stable.
- Banks and nonbanks, like insurers, engage in fundamentally different businesses, with different business models, balance sheets, and customer value propositions. These distinctions drive the rationale for having different regulatory frameworks applied to each.
- At its core, banking activity remains lending and maturity transformation—connecting savers to borrowers. In contrast, insurers allow customers to reduce their exposure to risk.
Panel Two: The potential for risk to shift to the shadow banking sector in response to banking regulation and the appropriate regulation of shadow banks
The panelists70 discussed how modern firms are responding to asymmetry in regulatory frameworks. The current regulatory framework is effective in an environment where banks and nonbanks (shadow banks) engage in a separate set of activities. Now, with the lines of activity blurring and shadow banks engaging in a higher volume of activity that was once the domain of the traditional banking sector, the differentiation between bank and shadow bank activity is less defined. This panel discussed this development and potential government responses. Key points include, but are not limited to, the following:
- Whereas traditional banking is characterized by highly regulated institutions that receive extensive public support (e.g., deposit insurance and lender of last resort), shadow banking is characterized by chains of transactions involving multiple intermediaries that are lightly regulated.
- Heightened regulation leads activity to migrate from regulated banks toward shadow banking or other more lightly regulated nonbank intermediaries. This potential for migration reduces the ability of regulation to correct underlying market failures and safeguard financial stability.
- Instead of the current practice where regulation is imposed upon certain types of institutions, several panelists suggested that financial regulation be activity-based.
- On the liability side, the issuance of debt by shadow firms, particularly short-term debt, presents concern by making these firms vulnerable.
- On the asset side, the concern focuses on assets that would take losses in a fire sale, which are also the assets that are the hardest to price and value.
- The flow of activity and potential risk from the banking to the nonbanking sector is a real threat. Intense regulation of banks makes it more costly to engage in these activities in the banking context. So the activities move to the shadow sector, which does not impose the same level of intense regulation. This leads to the types of liabilities and assets of concern being more present and important in a growing shadow sector.
- For example, some panelists mentioned reports of loans moving from banks to the nonbanking sector, funded by debt.
- Panelists discussed options for government response to this threat of activity migration from the banking to nonbanking sector.
- One panelist called for a prohibition on the issuance of short-term debt by any financial firm that is not a bank.
- Another idea included crafting new regulations to address the migration phenomenon.
Request for comments on the Minneapolis Plan to end too big to fail, November 16, 2016
The Federal Reserve Bank of Minneapolis has engaged throughout 2016 in a public process to determine the best ways to end the problem of too big to fail banks. We solicited feedback throughout the year, held town halls with the public and held four policy symposiums, which brought together experts with a wide range of perspectives on the problem and on potential solutions. The symposiums were streamed live on the web to allow the public to learn alongside the Minneapolis Fed. Video recordings and all presented materials are available on our website at minneapolisfed.org. Input from the public and experts around the world have shaped our effort.
Today, November 16, we released our proposal to end TBTF: the Minneapolis Plan. And as a continuation of our effort to both inform and learn from the public and experts, we continue to seek input. Specifically, the Federal Reserve Bank of Minneapolis seeks comments on its proposal to end TBTF.
Commenters should provide feedback by January 17, 2017, sixty days after the issuance of the proposal. Comments should be submitted via www.minneapolisfed.org/MPLSplancomments. Specific comments will not be made public, but the Minneapolis Fed will publish an aggregated summary of the comments when a revised version of the proposal is released.
The Federal Reserve Bank of Minneapolis welcomes feedback on all aspects of the Minneapolis Plan. Commenters can also provide feedback on the following specific questions:
- Benefit and Cost Analysis of Higher Minimum Equity Requirement
The Minneapolis Plan would increase the minimum equity requirement for banks with assets over $250 billion, reflecting an underlying analysis of the benefits and costs of higher capital.
(Q1) Are there improvements that the Federal Reserve Bank of Minneapolis could make to its calculation of the benefits of this aspect of the proposal?
(Q2) Are there improvements that the Federal Reserve Bank of Minneapolis could make to its calculation of the costs of this aspect of the proposal?
(Q3) Are there improvements that the Federal Reserve Bank of Minneapolis could make to its proposed minimum equity requirement for large banks?
- Benefit and Cost Analysis of a “Systemic Risk Capital Charge”
The proposal would create a Systemic Risk Capital Charge for all firms that the Treasury Secretary fails to certify as no longer systemically important.
(Q4) Are there improvements that the Federal Reserve Bank of Minneapolis could make to its calculation of the benefits of this aspect of the proposal?
(Q5) Are there improvements that the Federal Reserve Bank of Minneapolis could make to its calculation of the costs of this aspect of the proposal?
(Q6) Are there improvements that the Federal Reserve Bank of Minneapolis could make to its proposal calling on the Treasury Secretary to certify that firms are no longer systemically important?
(Q7) Are there alternative frameworks the Federal Reserve Bank of Minneapolis could use in reducing systemic risk of large financial firms?
- Setting a Shadow Banking Tax
The proposal would levy a tax on shadow banks.
(Q8) Are there improvements that the Federal Reserve Bank of Minneapolis could make to setting a tax on shadow banks within the framework set forth in the proposal?
(Q9) Are there alternative frameworks the Federal Reserve Bank of Minneapolis could use in setting a tax on shadow banks? What are they? How would a fee be calculated using these alternative frameworks? Why are they superior to the framework used in the proposal?
- Right Sizing Community Bank Supervision and Regulation
The proposal would create a separate and more appropriate supervisory and regulatory regime for community banks.
(Q10) Are there specific features of such a regime that the current proposal should include but does not?
(Q11) Are there specific features of such a regime that the current proposal includes that it should not?
Wall Street Journal Op-Ed, February 14, 2017
Make Big Banks Put 20% Down—Just Like Home Buyers Do
Financial CEOs say capital requirements are already too high, but the facts suggest otherwise.
By Neel Kashkari
There’s a straightforward way to help prevent the next financial crisis, fix the too-big-to-fail problem, and still relax regulations on community lenders: increase capital requirements for the largest banks. In November, the Federal Reserve Bank of Minneapolis, which I lead, announced a draft proposal to do precisely that. Our Plan would increase capital requirements on the biggest banks—those with assets over $250 billion—to at least 23.5%. It would reduce the risk of a taxpayer bailout to less than 10% over the next century.
Alarmingly, there has been recent public discussion of moving in the opposite direction. Several large-bank CEOs have suggested that their capital requirements are already too high and are holding back lending. As this newspaper reported, Bank of America CEO Brian Moynihan recently asked, “Do we have [to hold] an extra $20 billion in capital? Which doesn’t sound like a lot, but that’s $200 billion in loans we could make.”
It is true that some regulations implemented after the 2008 financial crisis are imposing undue burdens, especially on small banks, without actually making the financial system safer. But the assertion that capital requirements are holding back lending is demonstrably false.
How can I prove it? Simple: Borrowing costs for homeowners and businesses are near record lows. If loans were scarce, borrowers would be competing for them, driving up costs. That isn’t happening. Nor do other indicators suggest a lack of loans. Bank credit has grown 23% over the past three years, about twice as much as nominal gross domestic product. Only 4% of small businesses surveyed by the National Federation of Independent Business report not having their credit needs met.
If capital standards are relaxed, banks will almost certainly use the newly freed money to buy back their stock and increase dividends. The goal for large banks won’t be to increase lending, but to boost their stock prices. Let’s not forget: That’s the job of a bank CEO. It isn’t to protect taxpayers.
So if capital requirements aren’t the problem, why does it feel so hard to get a loan today? I can speak from firsthand experience. Last year my wife and I decided to buy a house. We applied for a loan with a bank where I have been a customer for many years. I assumed that my long record with the bank and our good credit would make it easy. With the required 20% down payment, we were prequalified for a mortgage with a rate of 3.375% fixed for the first 10 years. That was an attractive rate, suggesting capital was not holding back lending.
The prequalification was easy. Then the frustration began. The mortgage banker asked for myriad documents: bank statements, 401(k) statements, brokerage statements, tax returns, W-2s, insurance records and so on. That all seemed reasonable, but as the weeks rolled on, the requests for more documentation kept coming. After a month or so, I couldn’t believe what I was being asked for. Despite having all the records of my on-time monthly rental payments in my checking account, the bank demanded a copy of my lease and to speak with my landlord.
The banker called me to apologize, admitting that the requests were ridiculous but saying that there was no reasoning with the underwriting department. As we waited, we began to wonder if we wanted to buy the house at all. Wouldn’t continuing to rent be so much easier?
In the end, the bank funded the loan. I felt bad for the underwriters, who seemed unable to exercise judgment or use common sense. The impression I got was that people at the bank were simply paralyzed by fear—that they might make a mistake that regulators would be breathing down their necks.
I have spoken to many borrowers at other banks, and they tell me similar stories. It has become needlessly difficult for qualified borrowers to get loans. But again, the problem isn’t the capital requirements—it’s everything else.
Capital is the best defense against bailouts. Although capital standards are higher than before the last crisis, they are not nearly high enough. The odds of a bailout in the next century are still nearly 70%. Large banks need to be able to withstand around a 20% loss on their assets to protect against taxpayer bailouts in a downturn like the Great Recession, according to a 2015 analysis by the Federal Reserve. Unfortunately, regulators have taken it easy on the large banks, which today have only about half of the equity they need.
There is a simple and fair solution to the too-big-to-fail problem. Banks ask us to put 20% down when buying our homes to protect them in case we run into trouble. Similarly, taxpayers should make large banks put 20% down in the form of equity to prevent bailouts in case the financial system runs into trouble. Higher capital for large banks and streamlined regulation for small banks would minimize frustration for borrowers. If 20% down is reasonable to ask of us, it is reasonable to ask of the banks.
Mr. Kashkari is president of the Federal Reserve Bank of Minneapolis and a participant in the Federal Open Market Committee.
Medium post, April 4, 2017
Jamie Dimon’s Shareholder (Advocacy) Letter
By Neel Kashkari
On April 4, JPMorgan Chase Chairman and CEO Jamie Dimon published his annual shareholder letter, much of which focused on public policy and financial regulation. At 46 pages, Mr. Dimon’s letter includes a lot of interesting commentary. In this essay, I am going to respond to two of his main points because I strongly disagree with them. First, Mr. Dimon asserts that “essentially, Too Big to Fail has been solved — taxpayers will not pay if a bank fails.” Second, Mr. Dimon asserts that “it is clear that the banks have too much capital.” Both of these assertions are demonstrably false.
Too big to fail has not been solved
To make his argument that TBTF has been solved, Mr. Dimon repeatedly points to various regulatory schemes that all have the same unrealistic feature: In a crisis, bondholders will take losses rather than taxpayers. He refers to “bail-inable debt,” “total loss absorbing capacity,” “receivership where unsecured debt … would convert to equity,” “Chapter 14 bankruptcy” and “resolution.” All of these essentially mean the same thing: A bank runs into trouble; then either regulators or the courts trigger a conversion of debt to equity. Bondholders take losses. The firm is recapitalized and taxpayers are spared. Systemic risk is neutralized and bailouts are avoided. It sounds like an ideal solution. The problem is that it almost never actually works in real life.
We learned from past financial crises, including the 2008 financial crisis, that nothing beats equity for absorbing losses. Equity holders have long taken losses in the United States and thus expect that outcome. Moreover, equity holders cannot run during a crisis. In contrast, debt holders of the most systemically important banks in the United States and around the world have repeatedly experienced bailouts and likely will expect such an outcome during the next financial crisis. Indeed, the most recent crisis showed that even some debt holders who had been explicitly told that they would take losses during a crisis got bailed out.
Governments are reluctant to impose losses on creditors of a TBTF bank during a crisis because of the risk of contagion: Creditors at other TBTF banks may fear they will face similar losses and will then try to pull whatever funding they can, or at least refuse to reinvest when debt comes due. This is why, regardless of their promises during good times, governments do not want to impose losses on bondholders during a crisis. History has repeatedly shown this to be true and, while we can hope for the best, there is no credible reason to believe this won’t be true in the next crisis. Only true equity should be considered loss-absorbing in a crisis. The largest banks do not have enough equity today to protect taxpayers. Too big to fail is alive and well. Taxpayers are on the hook.
Large banks have too little capital, not too much
To make his argument that banks have too much capital, Mr. Dimon points to losses estimated by the Federal Reserve’s stress test and compares them to banks’ combined equity and long-term debt. Again, Mr. Dimon unrealistically assumes that debt will absorb losses in a crisis. As explained above, that is extremely unlikely. In addition, stress tests are just hypothetical scenarios. By definition, regulators (and bankers) won’t see the next crisis coming, and it will almost certainly look different from past crises, or scenarios modeled in a stress test.
Mr. Dimon argues that the current capital standards are restraining lending and impairing economic growth, yet he also points out that JPMorgan bought back $26 billion in stock over the past five years. If JPMorgan really had demand for additional loans from creditworthy borrowers, why did it turn those customers away and instead choose to buy back its stock?
The truth is that borrowing costs for homeowners and businesses are near record lows. If loans were scarce, borrowers would be competing for them, driving up costs. That isn’t happening. Nor do other indicators suggest a lack of loans. Bank credit has grown 23 percent over the past three years, about twice as much as nominal gross domestic product. Only 4 percent of small businesses surveyed by the National Federation of Independent Business report not having their credit needs met.
Capital is the best defense against bailouts. Although capital standards are higher than before the last crisis, they are not nearly high enough. The odds of a bailout in the next century are still nearly 70 percent. Large banks need to be able to withstand around a 20 percent loss on their assets to protect against taxpayer bailouts in a downturn like the Great Recession, according to a 2015 analysis by the Federal Reserve. Unfortunately, regulators have taken it easy on the large banks, which today have only about half of the equity they need.
Doubling the equity capital requirements for the largest banks would substantially address the TBTF problem and protect taxpayers. It also passes a cost-benefit test for society.
Areas of agreement
Mr. Dimon calls for reducing regulatory complexity, and I agree with this principle. In fact, a higher equity requirement produces the most protection for taxpayers in the simplest, most effective way. Once we have addressed TBTF by forcing large banks to fund themselves with far more common equity, I believe we can streamline other regulations, especially on small banks that have been severely burdened with regulation, but do not pose a systemic risk to society.
Wall Street Journal Op-Ed, July 9, 2017
New Bailouts Prove ‘Too Big to Fail’ Is Alive and Well
Regulators keep insisting bondholders will take losses, but then they’re reluctant to impose them.
By Neel Kashkari
Three strikeouts in four at bats would be barely acceptable in baseball. For a policy designed to prevent taxpayer bailouts, it’s an undeniable defeat. In the past few weeks, four European bank failures have demonstrated that a signature feature of the postcrisis regulatory regime simply cannot protect the public. There’s no need for more evidence: “bail-in debt” doesn’t prevent bailouts. It’s time to admit this and move to a simpler solution that will work: more common equity.
Bail-in debt was envisioned as an elegant solution to the “too big to fail” problem. When a bank ran into trouble, regulators could trigger a conversion of debt to equity. Bondholders would take the losses. The firm would be recapitalized. Taxpayers would be spared.
The idea, adopted both in the U.S. and Europe following the 2008 financial crisis, has its share of supporters, including JPMorgan Chase CEO James Dimon. “Essentially, too big to fail has been solved,” Mr. Dimon insisted in a shareholder letter earlier this year. “Taxpayers will not pay if a bank fails.” Wall Street also prefers this debt funding rather than equity because it is better for bank share prices. In theory, taxpayers and stockholders both win.
The problem is that it rarely works this way in real life. On June 1, the Italian government and European Union agreed to bail out Banca Monte dei Paschi di Siena with a €6.6 billion infusion, while protecting some bondholders who should have taken losses. Then on June 24, Italy decided to use public funds to protect bondholders of two more banks, Banca Popolare di Vicenza and Veneto Banca, with up to €17 billion of capital and guarantees. The one recent case in which taxpayers were spared was in Spain, when Banco Popular failed on June 6.
The largest of these four banks was less than one-tenth the size of $2.5 trillion JPMorgan. Think about that: If bail-in debt couldn’t protect taxpayers from a midsize bank failure when the global economy is stable, what are the odds it will work if a Wall Street giant runs into trouble when the economy looks shaky? Or how about when several giants are in trouble at the same time, as in 2008? Don’t hold your breath.
Why are governments so reluctant to force losses on bondholders? Sometimes they fear financial contagion. The argument holds water in the case of too-big-to-fail banks: If creditors at one large institution face losses, creditors at others may fear the same and try to pull their funding. Once the dominoes start falling, they are very hard to stop. This is why the Federal Reserve and the Treasury Department, with the support of Congress through the Troubled Asset Relief Program, intervened so dramatically to arrest the 2008 crisis.
When systemic risk isn’t an issue, governments may worry that bondholders are politically important constituents. In the recent Italian examples, the banks weren’t considered too big to fail, but the bondholders were retail investors. Regulators claimed that this was a unique circumstance, but there always seem to be unique circumstances when bailouts are concerned. What will happen if an important pension fund faces losses?
This is one more reminder that only equity can be counted on to protect taxpayers—and it needs to be raised in advance of economic distress. Although capital standards for America’s largest banks are higher now than before the last crisis, they are not nearly high enough. The odds of a bailout in the next century are still nearly 70%.
Large banks need to be able to withstand losses of around 20%, according to a 2015 analysis by the Federal Reserve. But they have only about half that amount in equity because regulators have generously assumed bondholders would take losses. Italy demonstrates that this is wishful thinking. Too big to fail is alive and well, and taxpayers are on the hook.
There is bipartisan support for fixing the problem, but it will require forcing large banks to raise much more equity. They won’t do it on their own, because their stock prices benefit when the public takes the risk. Indeed, banks are now moving in the wrong direction by increasing their dividends and stock buybacks. As a country, we must decide what’s more important: protecting taxpayers or bank investors.
Mr. Kashkari is president of the Federal Reserve Bank of Minneapolis and a member of the Federal Open Market Committee.
Public Town Hall, April 4, 2016
Immediately following the first policy symposium, a public Town Hall meeting on ending TBTF was hosted at the Minneapolis Fed.71 Attendance was open and free to the public.
Public Update to Minnesota Chamber of Commerce, April 18, 2016
Kashkari shared a public update on the Ending TBTF initiative by summarizing key points that he took away from the April 4 symposium.72 He also identified some important questions for further consideration:
- Should we view proposals to address TBTF in isolation, or could we combine them?
- How do the costs and benefits of proposed solutions line up relative to the status quo?
- How much confidence do we have that the solutions will perform as expected in a crisis environment?
- Will markets think the proposal credibly puts creditors at risk of loss?
- Will the solutions merely push risk into unregulated areas of the financial markets?
- Will the solutions promote fairness between the regulatory burdens imposed upon large, medium and small banks?
- How likely are the solutions to remain effective over decades?
Public Evening Discussion, May 16, 2016
Following the second policy symposium held at the Minneapolis Fed, an evening discussion was hosted by the Heller-Hurwicz Economics Institute at the University of Minnesota and moderated by CNBC’s chief Washington correspondent, John Harwood.73 This event was also open and free to the public.
Panelist on Ending “Too Big to Fail” Banks Discussion at the American Economic Association Conference, January 7, 2017
President Neel Kashkari participated in a panel discussion74 where he presented the primary elements of the draft Minneapolis Plan and received feedback from Randall S. Kroszner of the University of Chicago and Markus K. Brunnermeier of Princeton University. Wayne Passmore of the Federal Reserve System Board of Governors served as panel chair.
Presentation of the Draft Minneapolis Plan to the National Association of Business Economics, March 6, 2017
In an effort to share the draft Minneapolis Plan with a variety of interested audiences and to invite feedback on the Plan, President Neel Kashkari presented a set of summary slides75 to the National Association of Business Economics.
50 See the Minneapolis Fed Ending TBTF website at https://www.minneapolisfed.org/publications/special-studies/endingtbtf.
51 Public input and ideas were collected at https://www.minneapolisfed.org/publications/special-studies/endingtbtf/share-your-ideas.
52 See the first symposium’s agenda and materials at https://www.minneapolisfed.org/publications/special-studies/endingtbtf/symposiums/april-4-ending-too-big-to-fail-symposium-summary.
53 George G.C. Parker Professor of Finance and Economics at the Graduate School of Business, Stanford University.
54 Deborah Lucas, Distinguished Professor of Finance at the Massachusetts Institute of Technology Sloan School of Management; Adam S. Posen, President of the
Peterson Institute for International Economics; Til Schuermann, Partner, Finance & Risk and Public Policy Practices at Oliver Wyman, and former Senior Vice President of the Federal Reserve Bank of New York; Philip Swagel, Professor of International Economics at the University of Maryland’s School of Public Policy and Senior Fellow at the Milken Institute.
55 Ronald A. Kurtz (1954) Professor of Entrepreneurship, Sloan School of Management, Massachusetts Institute of Technology.
56 Joseph P. Hughes, Professor of Economics at Rutgers University; Aaron Klein, Fellow and Policy Director, Economic Studies, Brookings Institution; Ross Levine, the Willis H. Booth Chair in Banking and Finance at the University of California, Berkeley’s Haas School of Business; Eugene Ludwig, Founder and CEO of Promontory Financial Group.
57 Norman R. Bobins Professor of Economics, Booth School of Business, University of Chicago.
58 See the second symposium’s agenda and materials at https://www.minneapolisfed.org/publications/special-studies/endingtbtf/symposiums/may-16-ending-too-big-to-fail-symposium-ii.
59 Senior Fellow at the Hoover Institution, Stanford University.
61 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.
62 Co-chair of the Bipartisan Policy Center’s Failure Resolution Task Force.
64 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.
65 Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance and Charles M. Harper Faculty Fellow, University of Chicago Booth School of Business.
66 For more information, visit the PIIE website at https://piie.com/events/symposium-ending-too-big-fail. A recorded archive of the event can be found at the site: https://archive.org/details/SymposiumOnEndingTooBigToFail_648.
67 The panelists were William R. Cline, PIIE senior fellow; Giovanni Dell’Ariccia, deputy director of the International Monetary Fund’s Research Department; and Douglas Elliott, a partner in finance and risk and public policy practices at Oliver Wyman.
68 Panelists included Emilios Avgouleas, Professor (Chair) of International Banking Law and Finance at the University of Edinburgh and a member of the stakeholder group of the European Banking Authority; Mark Flannery, Director and Chief Economist at the U.S. Securities and Exchange Commission and BankAmerica Eminent Scholar in Finance at the University of Florida; Stuart Plesser, Senior Director in S&P Global’s North American Financial Institutions Ratings Team; and Larry Wall, Research Center Executive Director of the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta.
69 President and Chief Executive Officer of TIAA and former Vice Chairman of the Board of Governors of the Federal Reserve System.
70 Panelists were Viral V. Acharya, C. V. Starr Professor of Economics at New York University Stern School of Business; Samuel Hanson, Associate Professor of Business Administration at Harvard Business School; and Morgan Ricks, Associate Professor of Law at Vanderbilt Law School.
72 See the update to the Minnesota Chamber of Commerce at https://www.minneapolisfed.org/news-and-events/presidents-speeches/update-on-minneapolis-fed-ending-too-big-to-fail-initiative.
73 View video of the evening discussion hosted by the Heller-Hurwicz Economics Institute at the University of Minnesota at http://cla.umn.edu/heller-hurwicz/news-events/news/ending-too-big-fail.
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