Minneapolis Fed Policy Symposium on Ending TBTF
Federal Reserve Bank of Minneapolis
Ending Too Big to Fail Policy Symposium
Monday, June 20, 2016
Key Topics & Takeaways
- High Capital Requirements: Oliver Wyman’s Elliott discussed how regulations directly affect loan pricing and suggested that regulators have moved to the point where capital requirements are in excess of what the banks, rating agencies and markets would have demanded on their own, with banks now being forced to internalize the costs of the economic externalities of financial instability.
- Trouble with TLAC: Minneapolis Fed President Neel Kashkari highlighted several of his concerns with regard to Total Loss Absorbing Capacity (TLAC), namely his: 1) doubt that contingent convertible instruments will actually absorb losses in a crisis; 2) belief that the proposal relies “too heavily on supervisory wisdom;” 3) conviction that there is little benefit to maintaining the long-term debt requirement since it adds complexity without ensuring equity-like buffers will be available during a crisis.
- Three Major Concerns: The Peterson Institute’s Posen highlighted three major doubts about the current regulatory approach to ending TBTF, namely that: 1) it is unclear whether the consolidation that took place within the banking industry during and post-crisis addresses the underlying problem that many banks had unsustainable business models that were artificially propped up by risky products and lax supervisory standards; 2) financial stability is not just a function of size (i.e., in Europe, there were many instances in which small banks were the source of instability); and 3) the efficiency gains and stability of complex, universal banks are “at best overstated.”
Speakers
- William Cline, Peterson Institute for International Economics
- Giovanni Dell’Ariccia, International Monetary Fund
- Douglass Elliott, Oliver Wyman
- Neel Kashkari, President, Federal Reserve Bank of Minneapolis
- Bertrand Badré, Former Group Chief Financial Officer, Société Générale and Crédit Agricole
- Adam Posen, Peterson Institute for International Economics
Panel One: Review the Current Framework Used to Evaluate Proposals that Increase Capital Requirements as a Means of Addressing TBTF
William Cline, Peterson Institute for International Economics
Cline outlined the principal findings of his research, which he said suggests that the optimal level for tangible common equity is 7-8 percent of total assets, and that the optimal level of risk-weighted assets is about 12 percent. His model considered factors such as the frequency of crises and the damage they inflict on the economy, as well as the marginal benefits of additional capital. Cline stated that the benefits of higher capital seem to plateau at about 9 percent of total assets.
Cline concluded that while Basel III did not go far enough to end too big to fail (TBTF), the optimal level for capital is just one third higher than current requirements, rather than several times higher as some have suggested. He added that large U.S. banks already hold close to the bottom end of his optimal range, but argued that the higher end should be the target.
Giovanni Dell’Ariccia, International Monetary Fund
Dell’Ariccia explained that his work has focused on looking at past crises and determining how much capital would have been required for banks to absorb all losses without public recapitalization. He said holding 15-23 percent in risk-weighted assets would have avoided the majority of creditor losses, and added that any further increases would have “only marginal benefits.” Dell’Ariccia further commented that the costs of transitioning to higher capital are more significant than the long-term costs of holding this capital, and he therefore recommended a gradual imposition of higher requirements and that banks should be encouraged to raise equity rather than reduce their size.
Douglas Elliott, Oliver Wyman
Elliott stated that capital and liquidity are scarce and expensive resources for banks, and explained that their allocation and pricing mechanisms have a large effect on bank behavior. He said the literature on bank regulation has shown significant increases in bank funding costs resulting from Basel III, and stressed that policymakers should consider the effects of regulation on the price and volume of loans, market-making, and other services. Elliott further explained that equity is more expensive for banks than debt.
Elliott discussed how regulations directly affect loan pricing and suggested that regulators have moved to the point where capital requirements are in excess of what the banks, rating agencies and markets would have demanded on their own, with banks now being forced to internalize the costs of the economic externalities of financial instability.
Question and Answer
Asked about the benefits of higher capital as opposed to structural changes at banks, Elliott argued that there is “very little evidence” that structural reforms would decreases the severity of a crisis, noting that both pure investment banks and pure commercial banks had to be rescued. Dell’Ariccia suggested that restructuring and higher capital must both be studied in a holistic way.
Dennis Kelleher of Better Markets commented that the public pays the price in a crisis unless banks pay up front with higher capital. Elliott retorted that while crises are terrible things, long periods of repressed growth that result from high capital requirements also have a serious effect on people, wealthy and poor.
Panel Two: Take a Broad Look at What Current Policy Towards Banks leaves Unaddressed or Proves Problematic
Neel Kashkari, President, Federal Reserve Bank of Minneapolis
Kashkari noted that, since the 2008 financial crisis, regulators and policymakers have worked hard to make the financial system safer, and he recognized that many reforms “are headed in the right direction.” Still, Kashkari argued that these reforms do not go far enough, and he reiterated his commitment to develop a plan to address TBTF.
In summarizing his key takeaways from the Minneapolis Fed’s earlier two symposia on this theme, Kashkari claimed that there is broad agreement about the need to make “massive structural changes” to the current approach to regulating the financial system. He noted that some participants have seen the current regulations having the desired effect by forcing major banks to restructure. Kashkari also emphasized that many participants have called for a regulatory approach that does not shift risks to the shadow banking sector.
Kashkari highlighted several of his concerns with regard to Total Loss Absorbing Capacity (TLAC), namely his: 1) doubt that contingent convertible instruments will actually absorb losses in a crisis; 2) belief that the proposal relies “too heavily on supervisory wisdom;” 3) conviction that there is little benefit to maintaining the long-term debt requirement since it adds complexity without ensuring equity-like buffers will be available during a crisis.
Kashkari explained that the Minneapolis Fed’s ongoing work on these themes will culminate in it launching a plan to end TBTF by year-end.
Bertrand Badré, Formerly Group Chief Financial Officer, Société Générale and Crédit Agricole
Badré recalled that the financial performance and health of banks before the crisis was largely based on earnings statements, as opposed to capital and liquidity levels. He also referred to the use of internal models as a way for banks to increase their leverage pre-crisis, and explained that supervisors expected the market to price in the risk from banks operating with low capital buffers. Badré acknowledged that the “perception has changed completely” since the crisis, which has forced market participants to reconsider the way businesses are monitored and focus less on return-on-equity (ROE) and more on maintaining capital and liquidity buffers.
Despite progress made in Europe with establishing the banking union, single supervisory mechanism, TLAC, etc., Badré argued that the biggest concern is the complexity of modern banking. He claimed that “nobody really knows” how to price new products such as contingent capital instruments, and characterized the living will process as a “nightmare.” Badré explained that the central question for policymakers and market participants is deciding how they want to finance the economy, and he expressed concern that the current regulatory approach is moving from a system of TBTF to one that is too complex to succeed.
Adam Posen, Peterson Institute for International Economics
Posen highlighted three major doubts about the current regulatory approach to ending TBTF, namely that: 1) it is unclear whether the consolidation that took place within the banking industry during and post-crisis addresses the underlying problem that many banks had unsustainable business models that were artificially propped up by risky products and lax supervisory standards; 2) financial stability is not just a function of size (i.e., in Europe, there were many instances in which small banks were the source of instability); and 3) the efficiency gains and stability of complex, universal banks are “at best overstated.”
Posen also expressed doubt about the level of faith that policymakers and market participants put in capital standards, noting that financial crises in Sweden, Japan and Canada all occurred despite the fact that financial institutions held capital buffers well above the minimum capital requirements. Posen also argued that TLAC and living wills are a “terrible mistake,” as well as that contingent convertible instruments (CoCos) and bail-in securities “will not work.”
Question and Answer
In response to a question regarding the efficacy of having a bankruptcy or restructuring tool for financial firms, Kashkari argued that the problem during the 2008 crisis was not necessarily the lack of a viable bankruptcy option as much as it was the contagion effect destabilizing multiple large players.
On Glass-Steagall, Kashkari expressed doubt that having Glass-Steagall in place during the 2008 crisis would have led to a different outcome, though he explained that he is not opposed to reinstating the structural reform altogether. Posen expressed his support for separating retail from investment banking operations, and agreed structural reforms would be helpful.
In response to a question on international regulatory arbitrage, all three panelists agreed it is a concern. Posen underscored the destructive impacts that could take place from a regulatory race to the bottom (which he argued is a potential spillover effect of Brexit, for instance). Kashkari explained that some banks utilize the “ultimate scare tactic” by warning policymakers that U.S. banks may lose out to Chinese banks as a result of the regulatory reforms. He reiterated the “extraordinary” costs to society of major financial crises and argued that the U.S. should continue advancing reforms and capital markets efficiency to show the world that there is a better path forward.
For more information on this event, please click here.
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Federal Reserve Bank of Minneapolis
Ending Too Big to Fail Policy Symposium
Monday, June 20, 2016
Key Topics & Takeaways
- High Capital Requirements: Oliver Wyman’s Elliott discussed how regulations directly affect loan pricing and suggested that regulators have moved to the point where capital requirements are in excess of what the banks, rating agencies and markets would have demanded on their own, with banks now being forced to internalize the costs of the economic externalities of financial instability.
- Trouble with TLAC: Minneapolis Fed President Neel Kashkari highlighted several of his concerns with regard to Total Loss Absorbing Capacity (TLAC), namely his: 1) doubt that contingent convertible instruments will actually absorb losses in a crisis; 2) belief that the proposal relies “too heavily on supervisory wisdom;” 3) conviction that there is little benefit to maintaining the long-term debt requirement since it adds complexity without ensuring equity-like buffers will be available during a crisis.
- Three Major Concerns: The Peterson Institute’s Posen highlighted three major doubts about the current regulatory approach to ending TBTF, namely that: 1) it is unclear whether the consolidation that took place within the banking industry during and post-crisis addresses the underlying problem that many banks had unsustainable business models that were artificially propped up by risky products and lax supervisory standards; 2) financial stability is not just a function of size (i.e., in Europe, there were many instances in which small banks were the source of instability); and 3) the efficiency gains and stability of complex, universal banks are “at best overstated.”
Speakers
- William Cline, Peterson Institute for International Economics
- Giovanni Dell’Ariccia, International Monetary Fund
- Douglass Elliott, Oliver Wyman
- Neel Kashkari, President, Federal Reserve Bank of Minneapolis
- Bertrand Badré, Former Group Chief Financial Officer, Société Générale and Crédit Agricole
- Adam Posen, Peterson Institute for International Economics
Panel One: Review the Current Framework Used to Evaluate Proposals that Increase Capital Requirements as a Means of Addressing TBTF
William Cline, Peterson Institute for International Economics
Cline outlined the principal findings of his research, which he said suggests that the optimal level for tangible common equity is 7-8 percent of total assets, and that the optimal level of risk-weighted assets is about 12 percent. His model considered factors such as the frequency of crises and the damage they inflict on the economy, as well as the marginal benefits of additional capital. Cline stated that the benefits of higher capital seem to plateau at about 9 percent of total assets.
Cline concluded that while Basel III did not go far enough to end too big to fail (TBTF), the optimal level for capital is just one third higher than current requirements, rather than several times higher as some have suggested. He added that large U.S. banks already hold close to the bottom end of his optimal range, but argued that the higher end should be the target.
Giovanni Dell’Ariccia, International Monetary Fund
Dell’Ariccia explained that his work has focused on looking at past crises and determining how much capital would have been required for banks to absorb all losses without public recapitalization. He said holding 15-23 percent in risk-weighted assets would have avoided the majority of creditor losses, and added that any further increases would have “only marginal benefits.” Dell’Ariccia further commented that the costs of transitioning to higher capital are more significant than the long-term costs of holding this capital, and he therefore recommended a gradual imposition of higher requirements and that banks should be encouraged to raise equity rather than reduce their size.
Douglas Elliott, Oliver Wyman
Elliott stated that capital and liquidity are scarce and expensive resources for banks, and explained that their allocation and pricing mechanisms have a large effect on bank behavior. He said the literature on bank regulation has shown significant increases in bank funding costs resulting from Basel III, and stressed that policymakers should consider the effects of regulation on the price and volume of loans, market-making, and other services. Elliott further explained that equity is more expensive for banks than debt.
Elliott discussed how regulations directly affect loan pricing and suggested that regulators have moved to the point where capital requirements are in excess of what the banks, rating agencies and markets would have demanded on their own, with banks now being forced to internalize the costs of the economic externalities of financial instability.
Question and Answer
Asked about the benefits of higher capital as opposed to structural changes at banks, Elliott argued that there is “very little evidence” that structural reforms would decreases the severity of a crisis, noting that both pure investment banks and pure commercial banks had to be rescued. Dell’Ariccia suggested that restructuring and higher capital must both be studied in a holistic way.
Dennis Kelleher of Better Markets commented that the public pays the price in a crisis unless banks pay up front with higher capital. Elliott retorted that while crises are terrible things, long periods of repressed growth that result from high capital requirements also have a serious effect on people, wealthy and poor.
Panel Two: Take a Broad Look at What Current Policy Towards Banks leaves Unaddressed or Proves Problematic
Neel Kashkari, President, Federal Reserve Bank of Minneapolis
Kashkari noted that, since the 2008 financial crisis, regulators and policymakers have worked hard to make the financial system safer, and he recognized that many reforms “are headed in the right direction.” Still, Kashkari argued that these reforms do not go far enough, and he reiterated his commitment to develop a plan to address TBTF.
In summarizing his key takeaways from the Minneapolis Fed’s earlier two symposia on this theme, Kashkari claimed that there is broad agreement about the need to make “massive structural changes” to the current approach to regulating the financial system. He noted that some participants have seen the current regulations having the desired effect by forcing major banks to restructure. Kashkari also emphasized that many participants have called for a regulatory approach that does not shift risks to the shadow banking sector.
Kashkari highlighted several of his concerns with regard to Total Loss Absorbing Capacity (TLAC), namely his: 1) doubt that contingent convertible instruments will actually absorb losses in a crisis; 2) belief that the proposal relies “too heavily on supervisory wisdom;” 3) conviction that there is little benefit to maintaining the long-term debt requirement since it adds complexity without ensuring equity-like buffers will be available during a crisis.
Kashkari explained that the Minneapolis Fed’s ongoing work on these themes will culminate in it launching a plan to end TBTF by year-end.
Bertrand Badré, Formerly Group Chief Financial Officer, Société Générale and Crédit Agricole
Badré recalled that the financial performance and health of banks before the crisis was largely based on earnings statements, as opposed to capital and liquidity levels. He also referred to the use of internal models as a way for banks to increase their leverage pre-crisis, and explained that supervisors expected the market to price in the risk from banks operating with low capital buffers. Badré acknowledged that the “perception has changed completely” since the crisis, which has forced market participants to reconsider the way businesses are monitored and focus less on return-on-equity (ROE) and more on maintaining capital and liquidity buffers.
Despite progress made in Europe with establishing the banking union, single supervisory mechanism, TLAC, etc., Badré argued that the biggest concern is the complexity of modern banking. He claimed that “nobody really knows” how to price new products such as contingent capital instruments, and characterized the living will process as a “nightmare.” Badré explained that the central question for policymakers and market participants is deciding how they want to finance the economy, and he expressed concern that the current regulatory approach is moving from a system of TBTF to one that is too complex to succeed.
Adam Posen, Peterson Institute for International Economics
Posen highlighted three major doubts about the current regulatory approach to ending TBTF, namely that: 1) it is unclear whether the consolidation that took place within the banking industry during and post-crisis addresses the underlying problem that many banks had unsustainable business models that were artificially propped up by risky products and lax supervisory standards; 2) financial stability is not just a function of size (i.e., in Europe, there were many instances in which small banks were the source of instability); and 3) the efficiency gains and stability of complex, universal banks are “at best overstated.”
Posen also expressed doubt about the level of faith that policymakers and market participants put in capital standards, noting that financial crises in Sweden, Japan and Canada all occurred despite the fact that financial institutions held capital buffers well above the minimum capital requirements. Posen also argued that TLAC and living wills are a “terrible mistake,” as well as that contingent convertible instruments (CoCos) and bail-in securities “will not work.”
Question and Answer
In response to a question regarding the efficacy of having a bankruptcy or restructuring tool for financial firms, Kashkari argued that the problem during the 2008 crisis was not necessarily the lack of a viable bankruptcy option as much as it was the contagion effect destabilizing multiple large players.
On Glass-Steagall, Kashkari expressed doubt that having Glass-Steagall in place during the 2008 crisis would have led to a different outcome, though he explained that he is not opposed to reinstating the structural reform altogether. Posen expressed his support for separating retail from investment banking operations, and agreed structural reforms would be helpful.
In response to a question on international regulatory arbitrage, all three panelists agreed it is a concern. Posen underscored the destructive impacts that could take place from a regulatory race to the bottom (which he argued is a potential spillover effect of Brexit, for instance). Kashkari explained that some banks utilize the “ultimate scare tactic” by warning policymakers that U.S. banks may lose out to Chinese banks as a result of the regulatory reforms. He reiterated the “extraordinary” costs to society of major financial crises and argued that the U.S. should continue advancing reforms and capital markets efficiency to show the world that there is a better path forward.
For more information on this event, please click here.