What are the forces moving the Minnesota economy? Adam Belz tries to identify the trends and show the connections between Minnesota and the larger U.S. and global economies. You can connect with him on Twitter: @adambelz

Kocherlakota says to judge TBTF by credit default swap prices

Posted by: Adam Belz under Economics Updated: November 30, 2012 - 6:53 PM

Banks and their overseers should work on ways to measure “too big to fail” banks, the head of the Minneapolis Fed said Friday, even as the problem appears to be lessening.

Fed leader Narayana Kocherlakota said at a conference in Boston that his team has been working on possible approaches, though the task is difficult. The Dodd-Frank Act of 2010 mandates an end to banks that are so large their collapse can send shock waves through the world economy. 

Kocherlakota said one approach the Minneapolis Fed is using is to analyze the prices of credit default swaps on banks to look for the connections between prices and probabilities of default. 

If the prices on swaps aren’t as sensitive to the likelihood of default, the banks are “seen as being more likely to receive government support,” Kocherlakota said. They are, in the market’s judgment, too big to fail.

“Our preliminary work using this approach indicates that the size of the TBTF problem has fallen over the past couple of years but remains large,” Kocherlakota said.

Another method is to examine the difference between credit ratings that account for potential government support and credit ratings that do not. Those findings also indicate “too big to fail” is a persistent problem in the financial system.

These measurements are useful, Kocherlakota said. But, “it would be desirable to augment them with metrics” that can distinguish between the impacts of different government policies on banks.

Higher capital requirements, for one, should help persuade creditors that banks are safer. The publications of “living wills” — bank-written blueprints for their orderly dismantling — should give creditors comfort as well. Kocherlakota wants to know which policy does more good.

Wells Fargo, Morgan Stanley, Goldman Sachs, Bank of America, J.P. Morgan Chase and Citibank are all on the latest list of “global systemically important” banks put out by the Financial Stability Board. Also on the list are 22 other banks around the world.

Kocherlakota presides over the 9th District of the Federal Reserve, a territory including Montana, North and South Dakota, Minnesota, and northern Wisconsin and the Upper Peninsula. He is a non-voting member of the Fed’s rate-setting Federal Open Market Committee.

He has lately been a vocal proponent of holding down interest rates indefinitely, making speeches across the district arguing that rates should stay low until either unemployment falls below 5.5 percent or the medium-term inflation outlook rises above 2.25 percent.

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