Minneapolis Fed Policy Symposium on TBTF

Federal Reserve Bank of Minneapolis
Ending Too Big to Fail Policy Symposium
Monday, April 4, 2016

Key Topics & Takeaways

  • Higher Equity: Admati compared banks to non-bank corporations, noting that while non-banks rarely maintain less than 30 percent equity, banks are seldom above 6 percent. She argued that excessive leverage is expensive for society while increased equity would have a substantial social benefit.
  • Size Cap for Banks: Johnsoncalled for a “failsafe” measure to ultimately “stack the deck” in favor of regulators by instituting a “size cap” such that financial firms could not constitute more than 2 percent of GDP. He argued that if the Fed allows the financial system to continue in its current form, it is putting the economy and monetary system in jeopardy and putting the Federal Reserve System itself in the political firing line.
  • Arguments Against Breaking Up Banks: Several of the speakers, including Kroszner, Hughes, Klein, Levine and Ludwig, doubted the merits of breaking up large financial institutions and whether this would improve financial stability.


Welcoming Remarks

Neel Kashkari, President, Federal Reserve Bank of Minneapolis

In his remarks, Kashkari said the purpose of the symposium is to assess progress made since 2008 in addressing the systemic risks posed by the nation’s largest banks and to give “serious consideration” to bold options to solve too big to fail (TBTF). He said the goal of the Minneapolis Fed is to create a “sustained national conversation” about TBTF while leaving it up to the American people and their elected representatives to decide whether enough has been done. 

Panel One: Substantially Increased Capital Requirements

Anat Admati, Stanford University

During her presentation, Admati said the phenomenon of TBTF is part of an inefficient system that fails to provide basic safety, liability or accountability. She stated that the biggest banks have only grown since the financial crisis and criticized them for their opacity. On the post-crisis reforms, Admati called the living will process a “charade” that no globally systemically important financial institution (G-SIFI) could credibly pass and argued that stress tests provide false reassurances because they cannot predict contagion dynamics in interconnected markets. 

Admati stressed that more must be done to prevent failures, and that this is achievable “at a reasonable cost” by forcing banks to be better capitalized. She compared banks to non-bank corporations, noting that while non-banks rarely maintain less than 30 percent equity, banks are seldom above 6 percent. She argued that excessive leverage is expensive for society while increased equity would have a substantial social benefit. 

Recalling S. 798, the Terminating Bailouts for Taxpayer Fairness Act, introduced by Sens. Sherrod Brown (D-Ohio) and David Vitter (R-La.) in 2013, Admati said Congress should act now to increase equity and insisted that the Federal Reserve can act under Title I of the Dodd-Frank Act. However, she lamented, the obstacle in Washington is that “banks own the place.” 

Admati added that while equity is the “best bargain,” it is no “silver bullet.” She called for further reforms to the “counterproductive” bankruptcy and tax codes, the separation of banking activities and appropriate tailoring of regulations, and greater personal liability for executives for bank misconduct and losses. 

Deborah Lucas, Massachusetts Institute of Technology

Lucas, in her presentation, said cost-benefit analysis is a pressing need in the politically contentious area of financial regulation in order to build consensus about which rules best promote financial stability while minimizing costs. She also commented that there will always be some sort of government guarantee for TBTF firms, explicit or not, and suggested that such firms should be required to pay a “guarantee fee” that would fund this residual risk while also encouraging downsizing. 

Adam Posen, President, Peterson Institute for International Economics

Posen stated that he generally agrees with Admati on the need for higher capital. He said current equity levels are insufficient, and also questioned the Total Loss Absorbing Capacity (TLAC) proposal, suggesting that it is “over-engineered” and advocated for something simpler. 

Posen called on regulators to focus more on activities, given that capital requirements do not address risks in shadow banking. He then closed by urging that the public keep up pressure on the Federal Reserve and Congress to continue reforms because “we have to do more.” 

Til Schuermann, Oliver Wyman

Schuermann argued that bank capital nearly doubled between 2006 and 2015 while total assets have increased by less than half. He said stress tests are a useful measure in determining whether $1.4 trillion held in capital by the largest banks is sufficent. He noted that the stress test scenarios are comparable to what happened in the crisis and pointed out that firms have performed well in the exercises. Given this, he said he does not agree with Admati’s assertions on the need for more equity.

Phillip Swagel, University of Maryland; Milken Institute

Swagel noted in his presentation that increased capital requirements “save banks from themselves” and their own incentives, but also reminded that banks face competition from non-banks who should not necessarily face the same types of regulations. When thinking about failures, he said he questions TLAC based on a lack of clarity over who will buy TLAC debt and whether policymakers would hesitate to trigger the convertible debt and impose losses on investors. Swagel stated that much has been done to push out the frequency of financial crises, and he suggested that society may be willing to live with the possibility of crises happening less often as a tradeoff for growth. 


Randall Kroszner, University of Chicago

In his address, Kroszner stressed that successful regulatory reform requires first that the problem be diagnosed, to be followed by the proposal of alternative policies after the filtering of data, analysis of costs and benefits, and the assessment of current progress. Regarding analysis, Kroszner noted the importance of avoiding “analysis paralysis,” explaining the need to “move quickly” when analyzing. He stated three key “fragilities” to the current financial system: 1) leverage, not only found in financial systems, but also in the economy; 2) liquidity, which can be considered a cost or a benefit; and 3) securitization and interconnectedness between institutions. 

Regarding cost-benefit analyses, Kroszner explained that there must be enough credit to support economic growth, but not too much as it would result in destroying economic growth, and added that it would be “helpful” for the Minneapolis Fed to create parameters for such a tradeoff. He continued that while it is “crucial” for institutions to have more capital, it can create a false sense of confidence, and therefore there should not be a focus on “any one instrument.” Kroszner commented that breaking up the banks will not solve the problem of interconnectedness. 

During audience questions, Kroszner commented that he is unsure how resolution authority tools will work and that clarity is needed, adding that it would be helpful to conduct analyses similar to those conducted for stress tests to see how the TLAC will work. 

An audience member commented that the TBTF discussion seems to only happen in the U.S. and asked if there is something to gain in the global marketplace should TBTF end. Kroszner replied that baselines are needed so that international institutions can compete with each other, but that ending the problem should not prevent the U.S. from having a strong financial system. 

Panel Two: Altering the Organizational Structure of Financial Institutions

Simon Johnson, Massachusetts Institute of Technology

In his presentation, Johnson recalled the extraordinary actions that the Fed governors took in 2008 to provide financial assistance to financial firms, and noted that in former Chairman Ben Bernanke’s memoir, he claimed that it was not worth similar government intervention to rescue relatively small firms that were also failing. In the future, Johnson explained that it is important for policymakers to clarify when various creditors should expect to be protected, and what the criteria are to be designated TBTF. Ultimately, he argued, all firms should be able to fail, and policymakers should address the outcomes of the crisis, including the loss of gross domestic product (GDP) and the fiscal cost of rescuing financial firms. 

Johnson also discussed the amount of loss absorbing capacity held by large banks, and claimed that shareholder equity compared to total exposure for the largest banks was between 3-5 percent prior to the financial crisis, and that now it is approximately 5 percent. He further argued that “risk weights are always wrong” and concluded that there is not a lot of capital held by the largest banks in the system, generally. Johnson questioned whether the FDIC’s resolution power is going to work for global banks with a systemic footprint. Accordingly, he called for a “failsafe” measure to ultimately “stack the deck” in favor of regulators by instituting a “size cap” such that financial firms could not constitute more than 2 percent of GDP. 

Joseph Hughes, Rutgers University

Hughes, in his presentation, examined the costs and benefits of large financial institutions, and considered whether limiting the size of banks or breaking them up would work against market forces. Hughes noted several studies that find that bigger banks enjoy higher economies of scale due to more efficient use of technology, resulting in a lower average cost of products than those offered by smaller banks. However, he noted that ultimately the benefit of economies of scale is reduced or reversed by the increased risks assumed by the banks. Hughes cautioned that size restrictions would reduce the competitiveness of banks, which may create incentives for firms to avoid restrictions and thus push risks outside of the regulated financial system. 

Aaron Klein, Brookings Institution

Klein opened his presentation by stating that the “scars of the financial crisis have not healed.” While he claimed that bank “failure is good,” he proposed four questions to be asked before policymakers decide to break up the big banks: 1) Can I keep my bank? (i.e. should the structural reform be based on size or on functions, similar to the Volcker Rule restrictions); 2) What are the ramifications for global business with having no big US banks? 3) What does this mean for US capital markets? 4) Are we sure Dodd-Frank didn’t solve the problem? Klein argued that “risk weights are always wrong during a crisis” and urged policymakers to decide what level of risk they are willing to tolerate in the financial system, and then build solutions around that. He questioned how a breakup solution would improve upon or substitute any part of the Dodd-Frank Act. 

Ross Levine, University of California, Berkeley

Levine explained that “banks do a lot more than fail.” For instance, he stated, banks decide who starts and expands businesses, and who borrowers money to live in a community of their choice, among other things. Levine explained that banks even matter for people who rarely use them because they decide on the allocation of resources and affect the dynamism of the job market. As such, he called for “getting financial regulation right” in the “first order” because the core financial services provided affect the allocation of capital in the economy. 

Levine argued that regulatory reforms should be assessed based on their likely impact on important financial services, and stated proposals to break up banks do not achieve this. In fact, He maintained that there is “no evidence” that breaking up big banks would enhance economic prosperity. Levine maintained that the Dodd-Frank Act made the TBTF problem “much worse,” and claimed that the primary problem with TBTF is that big banks influence regulators. Still, he refuted the notion that breaking up the big banks would address TBTF since, he argued, doing so would not deal with the core issue which is the incentives of bank decision makers. Levine argued that taxpayer bailouts did not simply address the problem, but also provided financial assistance to the executives that ran the banks since the senior management teams did not change pre- and post-crisis. He suggested clawback provisions, a regulatory system that prohibits banks from having one large owner, and altering the compensation scheme for executives to have more “skin in the game” to address the incentives at the heart of the issue. 

Eugene Ludwig, Founder and CEO, Promontory Financial Group

Ludwig stated that the financial regulators should not set policy by “hunch,” and argued that there is no scientific evidence that illustrates that breaking up the big banks would be the best way to reduce systemic risk. He explained that artificially limiting the size of banks is not the right answer, and would instead likely increase systemic risk. 

Ludwig urged careful consideration of rules that have such profound impact on financial markets and the real economy. He explained that end-users rely on large multinational banks as safe and reliable places to effectuate their financial needs, and that the decision to use large banks is “not a matter of affection.” He further doubted that a large consortia of smaller banks would be able to step up to provide the necessary financial services if large banks were prohibited from doing so. Ludwig stated that he has yet to see convincing research on what would happen after breaking up the big banks. Further, he asked how failsafe policymakers want to make the financial markets, and he noted that some of the most serious financial crises took place when banks were thought to have strong capital levels “by any standard.” Ludwig claimed that forcing a breakup of largest financial institutions is a potentially “antiquated” notion in a global economy, and he urged further study on these themes. In addition, Ludwig noted that the government has already taken “significant” and “transformational” steps to ensure that financial institutions are not TBTF. He urged policymakers and academics to “take stock” to see how these government reforms are working before imposing additional constraints. 

Simon Johnson, Massachusetts Institute of Technology

In response to the panelists’ arguments, Johnson refuted suggestions that the evolution of large banks resulted in any positive social gain. He also rejected claims that large banks engender efficiencies in terms of economies of scale, and he stated that the independence and the credibility of the Federal Reserve are on the line in this debate. Johnson argued that if the Fed allows the financial system to continue in its current form, it is putting the economy and monetary system in jeopardy and putting the Federal Reserve System itself in the political firing line. 

In response to a question, Johnson closed by stating that the largest resolution plan is rumored to be 100,000 pages and he characterized the idea that it is possible to resolve a large bank as a “charade.” 

Closing Remarks

Neel Kashkari, President, Federal Reserve Bank of Minneapolis

In his closing remarks, Kashkari recalled the experience of responding to the financial crisis and urged policymakers to be “humble” about the political environment in which they operate. He also encouraged participants to continually assess whether the current regulatory framework is adequate to address TBTF, and claimed that events such as the day’s symposium are helpful to that end. Kashkari said that the next event in the series will be held on May 16. 

For more information on this event, please click here