Minneapolis Federal Reserve President Neel Kashkari wants to end ‘Too Big to Fail’ banks, and his proposals go farther than even Bernie Sanders. Oh, and Kashkari is a Republican…. (More)

“We won’t see the next crisis coming”

Yesterday Kashkari addressed the Brookings Institution in a speech that is worth reading in full. He offers three key lessons from the 2008 collapse:

I learned in the crisis that determining which firms are systemically important – which are TBTF – depends on economic and financial conditions. In a strong, stable economy, the failure of a given bank might not be systemic. The economy and financial firms and markets might be able to withstand a shock from such a failure without much harm to other institutions or to families and businesses. But in a weak economy with skittish markets, policymakers will be very worried about such a bank failure. After all, that failure might trigger contagion to other banks and cause a widespread downturn. Thus, although the size of a financial institution, its connections to other institutions and its importance to the plumbing of the financial system are all relevant in determining whether it is TBTF, there is no simple formula that defines what is systemic.[…]

A second lesson for me from the 2008 crisis is that almost by definition, we won’t see the next crisis coming, and it won’t look like what we might be expecting. If we, or markets, recognized an imbalance in the economy, market participants would likely take action to protect themselves. [From 2006-2008 the Treasury Department] looked at a number of scenarios, including an individual large bank running into trouble or a hedge fund suffering large losses, among others. We didn’t consider a nationwide housing downturn. It seems so obvious now, but we didn’t see it, and we were looking. We must assume that policymakers will not foresee future crises, either.

A third lesson from the crisis is that the externalities of large bank failures can be massive. I am not talking about just the fiscal costs of bailouts. Even with the 2008 bailouts, the costs to society from the financial crisis in terms of lost jobs, lost income and lost wealth were staggering – many trillions of dollars and devastation for millions of families. Failures of large financial institutions pose massively asymmetric risks to society that policymakers must consider. We had a choice in 2008: Spend taxpayer money to stabilize large banks, or don’t, and potentially trigger many trillions of additional costs to society.

“The risks … were simply too great”

Kashkari thinks the 2010 Dodd-Frank Wall Street Reform Act was a good start. But he notes that big banks have tried to block implementation at every step, and most of them don’t yet have complete ‘living wills’ if they face failure. More troubling, he is not convinced the current dissolution plans would reassure policymakers who faced a major bank failure in an otherwise healthy economy, let alone the 2008-like crisis of banks failing in a fragile economy:

Unfortunately, I am far more skeptical that these tools will be useful to policymakers in the second scenario of a stressed economic environment. Given the massive externalities on Main Street of large bank failures in terms of lost jobs, lost income and lost wealth, no rational policymaker would risk restructuring large firms and forcing losses on creditors and counterparties using the new tools in a risky environment, let alone in a crisis environment like we experienced in 2008. They will be forced to bail out failing institutions – as we were. We were even forced to support large bank mergers, which helped stabilize the immediate crisis, but that we knew would make TBTF worse in the long term. The risks to the U.S. economy and the American people were simply too great not to do whatever we could to prevent a financial collapse.

“Transformational measures”

With that in mind, Kashkari offers three possible solutions:

• Breaking up large banks into smaller, less connected, less important entities.
• Turning large banks into public utilities by forcing them to hold so much capital that they virtually can’t fail (with regulation akin to that of a nuclear power plant).
• Taxing leverage throughout the financial system to reduce systemic risks wherever they lie.

While breaking up ‘Too Big to Fail’ banks is the popular solution in the progressive media, Vox’s Matthew Yglesias writes that the second two options are even more radical:

Both these proposals are, essentially, extreme curbs on banks’ ability to finance their operations with borrowed money, which would make them a lot less profitable. Breaking up banks is something that would be really bad for the executives of the existing big banks and probably a little bad for their shareholders, but would still leave the banking industry as a whole in a prosperous condition. Curbing risk across the board would be more severe.

The New York TimesBinyamin Appelbaum explains that Kashkari’s third solution is actually the most comprehensive:

A third, broader approach would impose a tax on borrowing throughout the financial system, reducing risk-taking not just by banks but a wide range of other financial intermediaries. The role of banks in the financial system has declined over time, and many experts regard the rest of the financial system, relatively less regulated, as a more likely source of future crises.

“Cost/benefit analyses require understanding costs, too”

Kashkari then rebuts three common Wall Street objections:

Many of the arguments against adoption of a more transformational solution to the problem of TBTF are that the societal benefits of such financial giants somehow justify the exposure to another financial crisis. I find such arguments unpersuasive.

• Finance lobbyists argue that multinational corporations do business in many countries and therefore need global banks. But these corporations manage thousands of suppliers around the world – can’t they manage a few more banking relationships?

• Many argue that large banks benefit society by creating economies of scope and scale. No doubt this is true – but cost/benefit analyses require understanding costs, too. I don’t see the benefits of scale of large banks outweighing the massive externalities of a widespread economic collapse.

• Some argue that if we limited U.S. banks in size or scope, they would be at a disadvantage relative to banks in countries with looser regulations. If other countries want to take extreme risks with their financial systems, we can’t stop them – but the United States should do what is right for our economy and establish one set of rules for those who want to do business here.

It’s worth noting that Kashkari is hardly a liberal firebrand. In 2014 he was the Republican nominee for Governor of California, and he described himself as “a free-market Republican” to the American Enterprise Institute and “a pro-growth Republican” during his 2014 run in California.

But in his speech yesterday, he admitted an obvious fact that most Republicans stubbornly refuse to acknowledge: “markets make mistakes.” His proposals – I especially like the third one – would help to ensure that financiers themselves pay for their ill-judged risks …

… rather than privatizing their profits and socializing their losses.

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Photo Credit: AP Images

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Good day and good nuts