'Ending Contagion' Is the New 'Ending Too-Big-to-Fail'

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MINNEAPOLIS — As the Federal Reserve Bank of Minneapolis continues its yearlong inquiry into how to end "too big to fail" in the banking system, academics and economists are starting to home in on a different but related question: How do we keep financial contagion from creating financial crises?

Speaking before the second symposium here on Monday, John Cochrane, senior fellow at the Hoover Institution at Stanford University, presented a proposal to restructure the banking system by taxing leverage and having banks move toward a 100% equity model — effectively replacing deposits and other short-term bank debt with equity, which is not as subject to runs.

Without debt, Cochrane said, banks cannot fail, since the definition of failure is a bank that is unable to meet its debt obligations. If a bank cannot fail, its customers will have no incentive to withdraw their interests in the bank. He said his proposal would arrest the contagion of bank runs that led to bank failures in the 1930s and seized the short-term-credit markets in the financial crisis.

"Our financial crisis was a systemic run," Cochrane said. "Runs at specific individual institutions caused by identifiable problems [are] not really the danger. A specific contagion mechanism by which troubles at one institution spread to another because they cause people to worry about their own bank's assets — it's that systemic-run element that means banks can't easily sell cash, issue equity or otherwise handle problems."

Cochrane said that by insisting on a heavily equity-based banking system and taxing the extent to which banks — and nonbanks as well — rely on leverage is a way of minimizing the moral hazard of "too big to fail" while also avoiding the subjective and impossible task of assigning capital requirements at a level that makes institutions safe.

"We're not trying to carefully craft a way for banks to get by on the absolute minimum level of capital," Cochrane said. "We don't want to jigger the absolute minimum out of the tax. We want the tax to be enough to encourage the banks to shift overwhelmingly to floating-value, runproof securities. It's like a tax on cigarettes."

The question of whether the biggest banks are still "too big to fail" has been an increasing focus of regulators and politicians, even as the fallout from the financial crisis fades into memory.

The Minneapolis Fed kicked off its series of symposia earlier this year at the direction of newly appointed President Neel Kashkari, who oversaw the Troubled Asset Relief Program in the Bush Treasury in 2008 and who staked out the position that "too big to fail" still exists and that the largest banks may have to be forcefully broken up as a response.

But as the issue evolves, academics are beginning to think more broadly about what the problem is that "too big to fail" poses, and what the most desirable outcome form the discussion might be.

Cochrane is not the only one questioning the role of contagion in the debate.

Hal Scott, director of the program on International Financial Systems at Harvard Law School, argues in a forthcoming book, "Connectedness and Contagion," that the post-crisis reforms have been focused in large part on controlling interconnection between financial institutions while simultaneously reducing the Fed's ability to intervene in a crisis as liquidity provider of last resort. This ignores and exacerbates the real problem, Scott says, which is that contagion spurs people to withdraw their resources from otherwise healthy institutions out of an irrational fear.

"When I looked at what really was the heart of the problem in 2008, it was much more the freezing of credit, money market funds, short-term creditors, the drying up of short-term credit," Scott said. "A large part of the reform post-crisis was focused on the connectedness model. Everybody is connected in the global financial world — the question is, is this harmful?"

Scott said that Dodd-Frank's provisions curbing the Fed's ability to apply liquidity to troubled firms — codified in the Fed's recent revisions to its 13(3) authority, which require the Fed to offer liquidity to at least five similar institutions at the same time — essentially reduces the effectiveness of the one tool that can counter a contagious run on financial institutions. Instead, the debate to date has tended to focus on whether Dodd-Frank has gone far enough or whether the reform law could resolve a very large bank in an orderly way, not whether regulators could stop the panic that such a failure would trigger.

"If you were really interested in resolving TBTF you have to have weapons to stop contagion that would be set off by the failure of a very large institution," Scott said. "Nobody has really focused on that connection between bailouts … and 'too big to fail.' "

Oliver Ireland, a partner at Morrison & Foerster and former Fed official, agreed, saying that the insistence on ending taxpayer bailouts may be missing — or contributing to — the bigger problem, which is how to stop a panic once it's in progress.

"The real danger is panic," Ireland said. "Panic dries up market liquidity, the ability to fund longer-term assets disappears, people are selling assets into illiquid markets at depressed prices, which causes losses, depresses markets further — it's that downward spiral that is the greatest threat to stability."

Cochrane's proposal, for its part, was met with skepticism from the panel at the conference. Many of the experts on the panel were broadly supportive of the purpose of the proposal and the push for a simpler means of reducing the burden posed by overleveraged financial institutions in times of crisis. But most were also skeptical about whether the system would choose to be so radically transformed, or worried that the transformation from here to there would be unduly disruptive.

Donald Marron, Institute Fellow of Economic Policy Initiatives at the Urban Institute, said one of the biggest issues in using taxes to encourage or penalize certain economic activity is that taxation requires an act of Congress, and Congress as an institution is notoriously unwilling to revise taxes upward.

"If you talk about taxes, there's a group in society that gets really twitchy," Marron said. "In general, it is Congress that levies taxes, while it is agencies that collect fees. It is incredibly politically difficult to update taxes."

Reducing the restrictions on emergency lending in order to fight the effects of contagion is also politically unpopular, Scott said, and he is resigned to the likelihood that it will not happen until it is too late.

"I don't think there's any chance at all of rectifying this situation in the near term," Scott said.

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