Inside Financial Services

Another Misguided Banking ‘Reform’ Plan

Print Friendly, PDF & Email

From the Huffington Post, yesterday:

“I believe the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy,” Neel Kashkari, a former Goldman Sachs executive who worked for Treasury Secretary Hank Paulson during the George W. Bush administration, said at the Brookings Institution in Washington.

Kashkari, now president of the Federal Reserve Bank of Minneapolis, likened big banks to nuclear reactors and said the 2010 Dodd-Frank law championed by President Barack Obama to curb the risks large financial institutions pose to the economy “did not go far enough” to protect against a meltdown.

Instead, Kashkari said policymakers should give “serious consideration” to three proposals: Forcibly restructuring large banks into smaller ones, turning big banks into public utilities, or making it more expensive for all financial firms to use borrowed money. [Emph. added.]

Here we go again.  I have a suggestion: any proposal for major banking reform, be it from a Fed official or anyone else, should meet two tests. It should, first, it should be  able to credibly explain why it would have at least prevented the last financial crisis, and, second, it should be more than worth the cost it will inevitably bring in the form of higher interest rates and constricted creation of credit. From what I can see, Kashkari’s proto-scheme would do neither of these. Let’s go through his three proposals one at a time, and I’ll explain:

Break up the big banks: The financial crisis happened, as no one seems to remember anymore, not because the system was made up of too many of large, unwieldy institutions, but rather because the institutions in the system—both large and small—owned way too much of the same sour subprime mortgage debt, to the point that they eventually doubted the value of each other’s assets and became reluctant to fund one another. The system froze up. And the immediate source of the freeze wasn’t even a big bank! It was a money market fund that happened to own a bit of Lehman debt and (devastatingly, as it turns out) broke the buck as a result. At the peak of the crisis, something like $700 billion in mortgage debt was delinquent, and even mortgages that were current were viewed with suspicion. The entire credit market was a set of dominoes ready to fall, remember? After mortgages it was going to be auto debt, then credit cards, then commercial mortgages, and on and on. Nouriel Roubini was on TV every day! When a system is overwhelmed with bad and suspect credits on that scale, it doesn’t matter whether a few, large institutions own them, or many, many Kashkari-compliant smaller ones do. Either way, the system will be subsumed by fear and grind to a halt. If anything, large institutions are better equipped to deal with a debt crisis since they are more widely diversified, both by business line and by region. So, no, if the system were dominated by many smaller institutions rather than a few large ones, the crisis would have played out just as it did. The only difference would have been that many large, institutional banking customers would have had to turn to non-U.S. banks for their financial needs, since no U.S. institution would have been large or well-capitalized enough to serve them. Which, in my view, would have been a negative.

Turn big banks into public utilities. I’m not sure exactly what Kashkari means here. As it is, the banking industry is already so heavily regulated—by the OCC, the Fed, the FDIC, the CFPB, and the S.E.C., all empowered with new tools provided by Dodd-Frank—that big banks are already de facto public utilities. If you doubt it, look at how much more banks are spending, both in dollars and executives’ time, in compliance and regulation, than they did pre-crisis. At the big banks, regulators are on-site, year-round. Banks lately can’t even set their dividends without regulators’ approval. And don’t get me started on the annual stress tests. The typical bank ROE, post-crisis, is in the high-single digits, not so different from what electric utilities are allowed to earn. So if Kashkari wants to turn the banks into public utilities, I don’t know what he wants to happen that hasn’t already happened short of outright nationalization. As far as nationalization goes, government direct allocation of credit is not a good idea. Trust me on this.

Make it more expensive for all financial firms to use borrowed money—presumably by beefing up equity capital requirements. Kashkari talks about mandating a 25% capital ratio. Would-be banking reformers seem to have a fetish about higher capital requirements, and apparently think higher capital levels will engender more confidence in the system next time a crisis hits. They won’t. Think back to what was on people’s minds as they were panicking in 2008. I recall hearing people saying they assumed the eventual value of bad subprime mortgage debt would turn out to be zero. The tsunami of default was overwhelming, they believed, while the spiral down in home prices was so severe that it would crush recovery rates. And don’t forget, a wave of auto and credit card defaults were looming, too! Do you recall? In an environment like that, how much reassurance would a mere 25% capital ratio provide? None. During a financial panic, it’s not inadequate capital that’s the problem. No matter how strong your capital looks, people will assume it’s not enough. It’s inadequate liquidity is what grinds things to a halt. Which is why it always falls to the federal government, as the lender of last resort, to step in and prop up the system.  Sorry. Meanwhile, the one effect higher capital ratios would have would be to raise interest rates and crimp the availability of credit. I, for one, think that’s a bad idea and not worth the tradeoff.

So, as I say, Kashkari’s plan wouldn’t have prevented that last crisis (and wouldn’t likely prevent the next one, as far as that goes), and yet would be costly to the economy, in the form of constricted credit creation and higher interest rates. Since the credit crunch, the banking system has been heavily re-capitalized and re-regulated. Lending standards are much more conservative than they were during the subprime frenzy, and lending activity more widely diversified. All of which is to say Neel Kashkari’s proposed plan is a non-solution to a problem that doesn’t exist.

What do you think? Let me know!

14 Responses to “Another Misguided Banking ‘Reform’ Plan”

  1. Avatar Bob

    A politician in the making. I see a Senate race in his future.

  2. Avatar paul

    there is no way he actually believes what he is saying ! ?
    He already tried to run for something. He is letting out his inner Elizabeth Warren.

    Public Utilities ? Richard Cordray could decide who should get credit, that’s it.

    How does someone like Kashkari get into a position to a) become a fed governor b) make irresponsible statements. Janet Yellen needs to get her ruler out and smack his knuckles.

    • Avatar Anonymous

      Kashkari is an opportunist. Ran unsuccessfully as Repub. for Gov. of CA. Became Fed MN somehow. Likely now an Obama liberal supporter. Sees the winds of “break up banks” with Bernie Sanders. And should he win, angle for a position in his administration. This trial balloon got him coverage in WSJ. Two minutes of fame.

  3. Avatar Anonymous

    Re breaking up the banks: If a TBTF entity goes under, the creditors recover all their investment. At least that’s what happened with AIG, Fannie, Freddie, et al. And that’s where moral hazard comes in: creditors are willing to pump money into a TBTF bank that doesn’t deserve the money, because the creditor is thinking, “No matter what happens, I’ll get my money back.” Dodd-Frank didn’t change this.

    Spinoffs work in the industrial sector. They would work in the banking sector.

  4. Avatar EMC

    No insight into who would actually buy this hypothetical equity….cannot imagine investors want to own something with a 4%-5% ROE

  5. Avatar Tom

    It is always lack of liquidity and not lack of capital which causes a financial crisis…and the bigger banks can provide a liquidity solution before the fed is ultimately required.

  6. Avatar JohnACritic

    No bank should ever be “To Big To Fail.” What happened after 2008? the government bailed them out and since then they have grown even bigger. Does this make sense?
    Personally, I don’t like the way big banks are being run today. I would like to see Glass-Steagall reinstated, also break them up or put limitations of further growth. Big banks today don’t service the average person. Try getting a loan for 5 or $10,000, but if your a big business, they will give all you want. They do however come up with all kinds of fees to charge that average person. That’s not what banking should be about.

  7. Avatar etoleary

    Gov. Terullo of the FR Board and William Dudley of the NY FRB waded into this subject over a year ago. These men were concerned about and reacting to the behaviors that resulted in enormous fines and damage to many banks’ reputations. In that context, they allowed as how if the senior officers of large institutions didn’t gain control over the aberrant behaviors, the Fed might conclude that very large institutions were too big to manage. There are multiple ways to look at the TBTF issue and Kashkari’s plan, one perspective, is just dimwitted. But the Fed considers the assaults to bank reputations potentially developing into safety and soundness issues. There’s got to be a better way of “threading the needle” than the one proposed by Kashkari.

    Tom, I agree with you.

  8. Avatar Steve Goodenow

    I will never forget Kashkari telling all community banks and everyone else listening to the TARP rollout conference call presented by the ABA and U.S. Treasury to take TARP money and think of it as our patriotic duty to help stabilize the U.S. Economy. How dis that work out?

Comments are closed.