Neel Kashkari said Monday he is “even more committed to recommending transformational solutions to address the systemic risks posed by large banks,” and it appears he prefers a solution that raises capital requirements.

The president of the Federal Reserve Bank of Minneapolis, four months after announcing an initiative to end the phenomenon of too-big-to-fail financial institutions, said he sees broad agreement among financial stability experts that the largest banks in the United States are too big to fail.

Policymakers must “act now to fix this problem,” he said.

He also signaled how his thinking has evolved in the past few months, spending much of his speech outlining his skepticism that the solution to the problem is a mechanism whereby debt issued by banks can be converted to equity in a crisis, forcing creditors to take losses instead of turning to government for a bailout.

This idea has been floated by many experts, and involves instruments called contingent-convertible bonds, or CoCos, which are forms of debt issued by banks that turn into equity if a crisis hits. University of Minnesota economist V.V. Chari has championed this type of debt as a means of achieving greater financial stability.

But to Kashkari, such a strategy is too complicated and would be too difficult to implement in a crisis. He compared resolving a large bank in a crisis to dismantling an aircraft carrier in a hurricane.

“Do we really believe that in the middle of economic distress when the public is looking for safety that the government will start imposing losses on debt holders, potentially increasing fear and panic among investors?” Kashkari asked at the Peterson Institute for International Economics. “Policymakers didn’t do that in 2008. There is no evidence that their response in a future crisis will be any different.”

In contrast, Kashkari said, higher capital requirements are a simple solution.

“Increased capital, in the form of common equity, solves many problems,” Kashkari said. “It is the simplest and arguably the most powerful tool to make banks stronger.”

The downsides of such a policy should be looked at more closely, he said, including the potential negative economic impact of higher borrowing costs and the possibility that more risky banking activity would shift to non-banks like hedge funds and insurers.

If a tax on leverage is imposed on non-banks to level the playing field with banks, the questions of who it should be applied to and what the unintended consequences will be must be answered, he said.

“These are some of the questions we are going to continue to try to answer as our ending TBTF initiative proceeds,” Kashkari said.

Kashkari did not mention forcibly breaking up the big banks on Monday, though he pointed out that some banks are beginning to restructure in response to regulation.

 

Twitter: @adambelz