Thanks to the bank reform proposal just released by the Federal Reserve Bank of Minneapolis, we now know how much the regulatory reforms passed after the Great Recession actually lowered the odds of taxpayers someday having to bail out the biggest banks again.
Not a lot.
The Minneapolis Fed calculated the odds of at least one “public support event” over the next hundred years at 84 percent based on the rules as they stood before the 2008 financial crisis. In other words, we should have known that some kind of taxpayer bailout was likely sometime.
After the Dodd-Frank regulatory reforms were put in place, the odds of another crisis and taxpayer bailout only slipped to 67 percent. That still seems pretty likely.
“I’ve said to people, ‘Don’t you think we should bring that down?’ ” Minneapolis Fed President Neel Kashkari said last week, in a brief phone conversation after the Fed’s proposal was released.
He clearly thinks so, of course. Implementing what he and his colleagues simply dubbed the “Minneapolis Plan” would dramatically cut the odds of a bailout, largely by making the biggest banks keep a lot more shareholders equity on the balance sheet. That would enable them to absorb big losses and still keep the confidence of their lenders and depositors.
Requiring more capital of banks isn’t a stunningly original idea, but this proposal came with a calculation of bailout odds that we can all easily grasp. Opponents have likely already lined up economists to dispute these odds as nonsense, of course, yet it’s easy enough to see how the Minneapolis Fed may have just reset the terms of the debate.
Now even if a completely different set of reform ideas gets put on the table, those in Congress taking it up will have to ask themselves, “would this really drop the odds of another bailout to less than 67 percent?”
The Minneapolis Fed’s proposal is its answer to what to do with banks that are so big that they imperil the financial system if they tip over, a problem known as “too big to fail.” Work got going on this just after Kashkari took over the Minneapolis Fed’s top job at the beginning of the year.
While he lived through the last financial crisis as a Treasury official in charge of bailout programs, he found out soon after he arrived in Minneapolis that Fed officials here still thought too big to fail was a problem, too.
The plan they came up with is about 50 pages long, including footnotes and summaries of the public meetings held throughout the year. The proposal doesn’t argue that implementing it wouldn’t cost anything, because demanding the biggest banks to hold a lot more capital would likely come at the cost of slower economic growth. It’s just arguing that these costs are a lot cheaper than going through another financial crisis.
The basic idea is to increase the common equity of the biggest banks, and it’s important to understand why that’s the focus. What’s common about common equity is it doesn’t have any special rights. It’s the ownership in a company that comes last in line, behind the rights of bond holders who need to be paid back and preferred stockholders who get paid before shareholders, too.
Common equity is a bank’s real permanent capital. It declines if the bank gives it back to shareholders through dividends or stock purchases and, of course, if the bank absorbs losses.
Right now the biggest banks have a common equity requirement that’s essentially 13 percent of what’s called risk-weighted assets, as calculated in the plan. Step one of the Minneapolis Plan raises that requirement to 23.5 percent of these assets. The Minneapolis Fed picked that number as the best trade-off between costs and benefits.
While that much capital to cushion losses seems like a lot compared to current practice, it would only be enough to drop the odds of another bailout to about 39 percent.
Step two would demand even more equity capital of banks still deemed to be a risk to the financial system, up to 38 percent of risk assets. Implementing that would drop the 100-year odds of a bailout to just 9 percent.
The proposal also takes aim at big hedge funds and other “shadow banks” that might create a risk to the financial systems by stepping into the role now filled by the biggest banks, hitting these firms with taxes on borrowed money. And finally, the plan would ease the rules for much smaller banks.
The new capital rule kicks in for banks with more than $250 billion in assets, so it would include Minneapolis-based U.S. Bancorp, now at around $450 billion in assets and the country’s fifth biggest bank.
Why not just bust up the biggest banks? In effect this proposal would do that, because big banks would find it all but impossible to generate enough return on all that newly required capital to attract investors. Better to break up.
The Minneapolis Fed used a little math and an International Monetary Fund database to calculate the odds, along with the common-sense idea that having more capital lowers the chance that a big bank could fail. That in turn would lower the odds of losses — and fear — spreading until there’s the kind of financial system panic that causes governments to step in with taxpayers’ money to keep the whole system upright.
The proposal points out that the function of capital in the banking system is pretty much the same as a sea wall to protect against a tsunami. Building a wall high enough to take the risk of flooding to zero seems too expensive.
It’s now up to lawmakers and the incoming Trump administration to decide what to do with this plan, Kashkari said, because it’s not his job to lobby Congress. He and his colleagues are standing by to “contribute” if asked. Told that a sweeping change such as he’s proposed would seem to need a years’ long process of debate and refinement to come to fruition — if it ever did — he said he wasn’t so sure.
“My experience is that nothing happens until everything happens,” he said. “And when everything happens, it happens quickly.”