It seems like politicians, regulators and economists — from Sen. Elizabeth Warren to Federal Reserve Bank of Minneapolis President Neel Kashkari — have a new proposal almost daily for how to deal with the big banks.
Some urge breaking up the largest banks, while others suggest imposing punitive and unworkable levels of required capital. At least one academic, John Cochrane of the Hoover Institution, believes banks should be financed 100% with equity. But none of the critics are suggesting a realistic way to end "too big to fail" without inflicting serious damage to economic growth.
There have always been bank failures and always will be. The trick is to allow sufficient risk-taking to promote economic growth but not so much that it leads to widespread bank failures and panic.
Given the long history of financial crises, we should acknowledge that regulators, by themselves, are not capable of preventing failures without turning banks into public utilities — inhibited from taking sufficient risks to support essential economic growth. The failure to recognize this simple truth is a fatal flaw in the Dodd-Frank financial reform law hastily thrown on the books in an emotional pique following the housing crash of 2008-9.
This most recent crisis was absolutely not caused by America's mainstream commercial banks. The primary perpetrators consisted of a handful of large investment banks and S&Ls.
We need a system that assumes bank failures will occur and requires that the failures be handled in a way that punishes excessive risk-taking without devastating the economy or resulting in taxpayer bailouts.
Requiring large firms to increase their equity capital to breathtaking levels, say above 10% of assets, is not the answer. That will lower return on equity to the point that banks will be unable to raise sufficient capital to support growth and will be forced to shrink their balance sheets. This will result in the very companies and individuals who most need bank loans being denied access to banks. This is already happening throughout Europe and the U.S. today.
Unlike debt, equity capital is permanent and therefore marginally effective in imposing discipline. Equity investors cannot declare an "event of default," meaning they cannot demand their money back before it was previously due. Moreover, equity holders have upside profit potential and are therefore more tolerant of risk than creditors.
The solution is to require all creditors, other than insured depositors, to have to face risk of loss in a bank failure so that neither the Federal Deposit Insurance Corp. nor taxpayers lose any money.
Moreover, regulators should make clear that any term debt issued by insured banks or any other holding company subsidiary is at risk of loss in the event of their failure, not just debt at the holding company. Unfortunately, some regulators appear to favor the latter approach in resolution planning policies following the crisis, but that just creates moral hazard for creditors at the subsidiary level. The last thing we need is for the market discipline of term debt holders to apply only to the parent company — term creditors of bank and non-bank subsidiaries should also be at risk.
Equity requirements should be set at no more than 10% percent of a conservative, risk-based measure of an institution's assets, unless a larger amount is required based on specific supervisory concerns. This would be a strong capital level, while avoiding the excessive heights for capital requirements suggested by some regulators.
On top of 10% risk-based capital, preferred stock and unsecured term debt usually provide another 10% buffer at large banking companies. But the key objective under our proposal is that all unsecured debt holders must face the risk of loss. With all other creditors, besides insured depositors, also at risk, it is difficult to imagine that the FDIC, much less taxpayers, would ever incur losses in a bank failure.
Capitalization along these lines will not only protect the FDIC and taxpayers, it will impose discipline on the sophisticated debt holders, which will make failures much less likely. Let's let the market do its part in reining in risky behavior. A risky bank would have to pay higher interest to its debt holders, providing an incentive to management and the board to be prudent while also sending a clear signal to regulators. A bank that is too risky ultimately would not be able to issue term debt, forcing it to curtail growth.
Sometimes, a failure cannot be avoided. In those situations, we believe in a balanced approach for how to resolve the institution.
The House of Representatives is currently considering creating a special financial services bankruptcy court with specialized expertise to resolve bank failures using funds available from all capital providers to a bank. If this legislation becomes law, the bankruptcy court should be required to work hand-in-glove with the FDIC, which has thousands of talented professionals and decades of experience in resolving insolvent banks. The Federal Reserve could provide interim liquidity until the institution is sold or liquidated.
Alternatively, the FDIC could put the failed bank into a bridge bank operating under FDIC control with new leadership. The bank would continue to serve the needs of customers, while leaving the equity, term debt and perhaps a portion of the uninsured deposits at risk in the receivership. The bridge bank would be wound down or returned to the private sector in due course.
In addition, we need to focus on improving regulatory performance by getting back to the fundamentals. Adding more bureaucracy and mind-numbing complexity, as Dodd-Frank did, has been a big step in the wrong direction.
We need a regulatory system that has the political will, independence and financial skill to take swift, strong actions when excessive risk-taking begins to develop. More streamlined, independent and effective regulation, coupled with greater market discipline by placing sophisticated bank creditors at risk, will significantly reduce moral hazard and end taxpayer bailouts.
Richard M. Kovacevich is the retired chairman & CEO of Wells Fargo. William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is senior managing director and global head of financial institutions at FTI Consulting. The views expressed are their own.