Kashkari's Plan to End TBTF Comes at High Price

NEW YORK — Minneapolis Federal Reserve Bank President Neel Kashkari outlined a dramatic proposal that he says will all but eliminate the risk of another financial crisis, albeit at a cost that is nearly quadruple that of the current post-crisis regulatory framework.

Almost exactly nine months after he declared that the biggest banks are still "too big to fail," Kashkari on Wednesday revealed the long-awaited result of his regional bank's inquiry into how to better reduce the risk of both a financial crisis and the need for the government to bail out faltering banks. He said his resulting proposal would solve the problem once and for all, but it wouldn't come cheap.

"Regulations can make the financial system safer, but they come with costs of potentially slower economic growth," Kashkari said. "Ultimately, the public has to decide how much safety they want in order to protect society from future financial crises and what price they are willing to pay for that safety."

But critics have wasted little time in highlighting the plan's costs, and Kashkari himself said he is uncertain of whether the plan will be seriously considered by the new Republican majorities in Congress as a new direction for regulatory policy.

The Kashkari plan has four core pillars:

Capital — The first provision would narrow the definition of capital to include only common equity – and then raise the minimum requirement for banks with more than $250 billion of assets to 23.5% of risk-weighted assets from its current level of roughly 13%.

Certification — The U.S. Treasury secretary would be required to certify that those banks are not "too big to fail." If he or she will not do so, the bank must retain additional capital under the certification is granted, up to a ceiling of 38%. This process, Kashkari said, is designed to push banks to restructure themselves in such a way as to make them less complex and reduce the risk of failure and the spread of market contagion.

"We believe the threat of these massive increases in capital will provide strong incentives for the largest banks to restructure themselves so that they are no longer systemically important," Kashkari said. "Any bank that remains TBTF will have so much capital that it virtually cannot fail."

Kashkari clarified that he is relatively agnostic about whether the Treasury secretary or some other agency – such as the Financial Stability Oversight Council, the Federal Deposit Insurance Corp. or the Fed itself – would be the suitable venue for such certifications, but the maneuverability of the Treasury and the accountability of that office to the president and the public might make it the best option.

Taxing shadow banks — The Minneapolis Plan would also impose a tax on so-called shadow banks with more than $50 billion in assets — including hedge funds, mutual funds, and financial intermediators – of between 1.2% and 2.2%, depending on systemic risk. Such a tax would "roughly level the playing field" between the banking and nonbanking sectors, he said.

Regulatory relief — The plan would reduce and streamline the regulatory burden on small banks with less than $10 billion of assets, which "have a vital role to play in American communities" and represent a "relative lack of risk to the economy," Kashkari said.

Kashkari acknowledges these changes carry a high price tag, saying it would put a meaningful dent in economic growth.

But Americans get something for their money, Kashkari said.

"If the Minneapolis Plan prevents one financial crisis, it will have paid for itself multiple times over," Kashkari said. "These are the trade-offs the public needs to understand in order to assess whether we have done enough to end 'too big to fail' or if we should go further."

The public notwithstanding, it is doubtful that a soon-to-be-Republican-controlled Washington is going to want to go further. President-elect Donald Trump won the White House with a campaign that has by turns tapped into the unsettled anger that many feel toward the excesses of the financial industry, but has also pushed for an anti-regulatory agenda centered on economic growth.

The first murmurs from Trump's transition team have suggested that he will push for a pro-growth agenda, making it unlikely that Kashkari – the Republican candidate for governor of California in 2014 – has mapped out a course for the future that the GOP is going to embrace.

And initial reactions from the financial services sector have been predictably critical of the plan's drag on growth.

"For those looking to accelerate economic growth and job creation, tripling bank capital levels – already double from pre-crisis levels – will make it much harder to meet those goals," said Laena Fallon, spokeswoman for the Financial Services Forum.

Kashkari appears to have anticipated this blowback, saying that the plan as envisioned would surely require legislation to go through Congress, and he is not clear on whether lawmakers will care to do that. But he said his concerns are with creating well-researched and well-founded policy proposals, and it is up to the public and their representatives in Congress to listen to them.

"I don't know what the current political climate means, in terms of the prospects for this plan," he said. "We're not a political organization – our jobs are to identify risks where we see them ... and let Congress and the public react to the, and I hope they'll give this serious consideration. But I can't forecast it."

Wall Street critics, meanwhile, were critical of the plan for precisely the opposite reason – that it overestimates the economic drag of higher capital requirements, making such a proposal appear less appealing than it really is. Simon Johnson, professor at the Massachusetts Institute of Technology School of Business and frequent advocate for higher capital rules, said the Minneapolis Fed got this dynamic wrong.

"They think higher capital will slow growth, but the opposite is the case. If you lower capital requirements, the banks like it, you get some boost in credit, and then the economy blows up," Johnson said. "I'm afraid that as much as I respect people in the Minneapolis Fed, they have fundamentally misunderstood the key point about capital and growth and financial stability."

Regardless of the plan's future, it does provide a sobering quantification of the holistic costs of financial crises and the relative costs, and benefits, of regulation. A financial sector under the Minneapolis Plan would look very different from the sector today, Kashkari said, and that could be appealing to Wall Street critics.

"We will have fewer megabanks, and there will be far less concentration in the banking system," Kashkari said. "We expect that community banks will thrive and midsize banks will make up a far larger share of the overall system. If there are any TBTF banks left, they will be so well capitalized that their risk of failure will truly have been minimized."

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