Neel Kashkari, a former Goldman banker and former candidate for governor of California, is clearly a man with ambition. Since joining the Minneapolis Fed just over a year ago, he has not been content with making gnomic monetary policy pronouncements or carefully-caveated economic predictions. He’s launched an effort to totally overhaul banking regulation, with the aim of ensuring no US institution is too big to fail.
It’s emblematic of US disdain for international bank capital rule making. US officials want the Basel process to continue, but domestic political discussion focuses on keeping Dodd-Frank (or not), or other grandiose schemes such as the Brown-Vitter plan to boost capital ratios to 15%, and now Kashkari’s idea — bringing risk-weighted capital up to 23.5%, and eventually to 38%. Shadow bank leverage would be taxed, and there would be incentives for big banks to break up so that they were “right-sized community banks”, and therefore subject to far more modest solvency rules.
Kashkari’s plan has a series of suspiciously precise predictions about future banking crises. Apparently there was an 84% chance of a bailout in the next 100 years under 2007 regulations, but this has come down to 67% today, and could be cut to 39% under the first phase of Kashkari’s approach.
Suspiciously precise predictions about the future were arguably the defining characteristic of the failed 2007 regulations, but leaving that aside, the paper is actually a little too limited in its ideas.
The mirror of real life
Take deposits. A big increase in the extent to which banks are funded through equity means, for a given volume of lending, a big reduction in the volume of debt liabilities, which presumably has to include deposits, or short-term deposit-like instruments like ABCP.
These aren’t going to go away any time soon, because, in aggregate, the banking system has to mirror real life. While households want to borrow long-dated mortgages but withdraw deposits at a moment’s notice, banks and the financial system have to be on the other side of the trade.
Different regulations can slice up the different pieces of maturity transformation. Perhaps money market funds transform overnight liabilities into 30 day assets, while banks transform 30 day liabilities into five year assets, and funds transform one year liabilities into 30 year assets. But somebody always needs to do the transformation.
Society also wants its deposits risk-free, and “information insensitive”. A dollar, pound, or euro in the bank needs to be as good as any other, regardless of which bank it is in, unlike the long-term liabilities of those same banks. Depositors don’t want to do the work of bondholders is monitoring the credit risk of their bank.
Part of what’s supposed to make deposits risk-free is that banks have an equity cushion protecting them, but a bigger part is government guarantees for retail deposits. This feels awkwardly like a bug in the system, in that can be considered a subsidy for deposit-taking institutions, but that’s the whole point. A 38% minimum capital cushion, such as Kashkari proposes, makes deposits pretty bombproof, but a government guarantee makes them all the same amount of bombproof.
Tinkering at the edges
On the other side of the balance sheet, you run into the same kinds of problems. Tinkering with risk-weights and regulation might push certain kinds of lending and leverage structure in or out of certain kinds of investment vehicle.
Maybe there are reasons to lend secured, to lend into securitization assets, to lend as leverage to a fund, or underwrite and hold securities. Financial regulation can tip the balance one way or another, and encourage companies and households to structure their borrowing a certain way.
But it’s hard to see how pure financial regulation can do much to change the total amount of debt finance the non-financial economy wants to borrow. Macroeconomic conditions, the corporate investment rate, the tax treatment for debt and equity, and real economy asset prices likely all have a bigger role to play.
Now, there is a radical solution to both sides of the problem. Nearly every deposit was, at some point, a loan – every liability is someone else’s asset. Lower asset prices, less debt finance, smaller bank balance sheets, and the de-financialisation of the whole economy might lead to the place Kashkari wants to be in. But getting there will be seriously painful. It means paying back, writing off, or inflating away debt, and it’s not like policy makers haven’t been straining every sinew to make some combination of those three measures happen since 2008.
Painful as re-regulating the financial system has been, it’s a picnic compared to making developed economies structurally less dependent on both borrowing, and risk-free deposits.
Do this, and the banking sector will end up less leveraged. Fail to do it, and money will always find a way to flow around the regulations to do what society wants it to. There are some heretical approaches to the problem — UK pressure group Positive Money suggests nationalising deposits, direct monetary financing of government by central banks and abolishing private fractional reserve banks — but that’s the kind of big thinking you need to end TBTF, and you have to wonder if it’s worth it.