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Thoughts On the Minneapolis Fed’s Plan to End Too Big to Fail
Last week the Federal Reserve Bank of Minneapolis released the final version of its Plan to End Too Big to Fail. The final version looks…
Last week the Federal Reserve Bank of Minneapolis released the final version of its Plan to End Too Big to Fail. The final version looks much like the initial version that was unveiled in late 2016. I thought at the time that the Plan’s overall objective of calling for banks to fund with more equity capital made sense. Still, I do have some reservations, as the both the initial and final versions seem too complex.
To begin, the Plan still calls for the US Treasury Secretary to declare whether a financial institution is systemically important, indicating that its failure could bring on a financial crisis. I am not yet convinced that this can be done, but this underlies Steps 1, 2 and 4 (although not 3) of the Plan.
Step 1 of the plan calls for financial institutions with at least $250 billion in total assets that are deemed not systemically important to meet a 23.5 percent equity to risk-weighted assets ratio and a simpler 15 percent equity to total assets leverage ratio. The two ratios differ only because of what’s in the denominator. While I have no problem with the second ratio, I see no reason to use the first ratio.
As I discussed in a recent working paper, the 2001 Recourse Rule lowered the amount of equity capital required for bank holding companies that held highly rated, private label securitization tranches, including those from structured finance collateralized debt obligations. Since I find that holding companies with more of those highly rated tranches were at a much greater risk of default in 2008, risk-weighted capital requirements could well have undermined the benefits of higher regulatory capital requirements that the Basel guidelines were supposed to have generated in the first place. Moreover, Federal Deposit Insurance Corporation (FDIC) Vice Chairman Thomas Hoenig suggested in a 2015 speech that risk-weighted capital requirements pose non-trivial compliance costs on smaller banks. Therefore, I would argue that risk-weighted capital requirements always have the potential to lower the effectiveness of higher capital requirements, while imposing additional compliance costs on banks. Instead, as my co-author James R. Barth and I found in a recent working paper, a simpler higher leverage ratio should work just fine.
Step 2 calls for those financial institutions with at least $250 billion that are deemed systemically important to have their equity to risk-weighted asset ratios increased further from 23.5 percent (which as I mentioned earlier translates to a 15 percent leverage ratio) to 38 percent (which translates to a 23.75 percent leverage ratio). As with Step 1, while I have no concerns about raising equity capital requirements, I’m not convinced that the benefits of risk-weighting outweigh the costs. So why not just use the leverage ratios?
Step 3 calls for taxing leverage for shadow banks that have at least $50 billion in total assets. The logic behind this proposal seems to be that if you increase commercial bank capital requirements, shadow banks might take more risk. However, in a recent working paper Juliane Begenau and Tim Landvoigt show that higher capital requirements results in a larger, rather than a riskier, shadow banking system. Moreover, many shadow banking activities seem to have emerged as a way to get around existing regulations (e.g., money market mutual funds and securitized banking). The debate should focus more on the problem of regulatory complexity that fosters regulatory arbitrage, rather than just leverage.
Step 4 in the final version now includes a more explicit call for regulatory relief for community banks. This includes a suggestion to return to Basel I regulatory capital standards for bank holding companies with under $10 billion in total assets. This step sounds much like FDIC Vice Chairman Thomas Hoenig’s proposal (and I’d discussed the preliminary version of the proposal in a recent post). However, a key difference is that the Hoenig proposal calls for eliminating risk-weighted capital requirements. So while the Hoenig proposal calls for a smaller increase in equity capital requirements for larger holding companies than the Minneapolis Fed Plan, it otherwise seems to envision a world with higher equity capital requirements and less regulatory complexity.
Comments on Responses to Comments
After the release of the initial version, the Federal Reserve Bank of Minneapolis welcomed comments from the public, and the final version of the Plan includes staff responses to comments. Since comments 17–20 seem to refer to my public interest comment, I thought I’d address the responses.
The Minneapolis Plan makes no explicit mention of market discipline as a means to end TBTF. Replacing regulator discretion with market discipline is necessary.
We agree. But creditors of banks must believe they will suffer losses in the event of a bank failure in order for market discipline to replace regulator discretion. The question is, therefore, how to convince bank creditors that they are truly at risk of loss. The simplest answer is to focus on creditors on whom the U.S. government has historically been willing to impose losses. Equity holders are that group of bank creditors. For that reason, the Minneapolis Plan focuses on common equity as the most robust form of capital for absorbing losses. Under current proposals, long-term debt counts toward measures of total loss-absorbing capacity (TLAC). We do not believe long-term debt will actually absorb losses in a time of market stress, particularly since it has not done so in the past.
While I agree with the points raised in response 17, the issue I was raising was more about whether current bank capital regulations reflected market discipline. I made the comment in the paragraph that ends at the top of page 2. I mentioned in that paragraph leading up to comment 17 that we used to have market discipline during the period between the passage of the National Bank Acts of 1863 and 1864 and the Federal Reserve Act of 1913.
This claim was based on extensive research by, among others, Rutgers University financial historian Eugene White, who showed that National Banks operated under double liability during that period. Under double liability, shareholders could not only lose their initial investment as equity investors can today, but they could also be held liable for creditor losses up to an amount equal to the par value of the stock. White also showed that during that period because shareholders did not want to be exposed to double liability, about eight out of every ten bank closures were voluntary liquidations rather than failures. Banking crises were much less costly during that time, as I discussed in a contribution on Medium last year.
White also suggests that it was the introduction of discount window lending that undermined the effectiveness of double liability, since weak banks now had a reason to remain open longer. Since the Plan makes no mention of eliminating discount window lending, it might make little sense to talk of restoring double liability here. Still, within the existing framework, an alternative way to address market discipline could be to rely on an alternative measures of bank equity capital.
For instance, one problem with current regulations is that they rely on book value measures of equity. Unfortunately, book values do not fluctuate much over time. So when a bank holding company’s performance starts to decline, book values may understate the extent of its poor performance. Market discipline could still be introduced within the existing framework. This might entail replacing book value with the median or average market value of a bank holding company’s shares during some period of time (e.g., a month or a quarter), as I discussed in a recent public interest comment.
The Minneapolis Plan focuses on bank holding company size rather than banking activity. Banking activity leads the government to support banking firms in times of distress rather than bank size per se.
The Minneapolis Plan accounts for both size of bank and bank activities. Specifically, the treatment that banks face under the Minneapolis Plan varies by two factors: asset size and systemic risk. Banks that are larger and more systemically important face higher capital charges under the Minneapolis Plan. An important measure of systemic importance is the particular activities that the firm engages in. Under the Minneapolis Plan, the Treasury Secretary will have to certify when banks are not systemically important. The Secretary must review the systemic risk of covered banks, but can identify banks that would otherwise be “not covered” as systemically important with the need to face higher equity capital requirements.
Regarding response 18, I acknowledge that the Federal Reserve Bank of Minneapolis Plan accounts for asset size and systemic risk. However, the point I was raising concerned commercial bank holding companies leading up to the crisis. Specifically, those securitizing assets, which also tended to hold onto the highest rated tranches, were also at risk of experiencing default. I mentioned in a post in August 2017 that losses on collateralized debt obligations reported by the largest of these securitizing commercial bank holding companies exceeded the resources available in the Deposit Insurance Fund. Rather than identifying a bank as systemic, a more sensible approach might be to identify an activity, such as securitization, as one that has the potential to create system-wide problems. In other words, it’s not the entity that’s systemic, but rather certain activities funded extensively by short-term debt that can be prone to a system wide run or rollover risk.
Addressing TBTF requires the government to set equity requirements at the bank level, not at the bank holding company level as the Minneapolis Plan does.
We disagree. The Minneapolis Plan sets equity requirements at the holding company level for two reasons. First, the government provided support in the last crisis at the holding company level for some firms. Second, issuing increased equity at the banking subsidiary may not adequately protect the bank from losses that threaten the parent company. These losses can arise from any part of the organization.
I made this comment in the second paragraph on page 4. The Federal Reserve Bank of Minneapolis’s response 19 seems to rest on the Federal Reserve’s so-called “source of strength” doctrine, which holds that in times of distress a holding company will come to the rescue of a failing bank. Yet Paul Kupiec has documented cases when the “source of strength” doctrine was violated, as holding companies have allowed banking subsidiaries to fail (see section 6 of his paper). Also, consider that the Hoenig Proposal does specify capital requirements at both the holding company and bank subsidiary level. A key reason why many favor higher equity capital requirements is that it will shield depositors and tax-payers from exposure to bank losses. Ensuring subsidiaries are funded with adequate equity capital could address the shortcomings of the “source of strength” doctrine, while at the same time shielding depositors and tax-payers.
Equity requirements should be based on the liabilities of banks, not on the assets.
The government can express equity requirements as a ratio with many options for what is used as the denominator. Our analysis, like all others we are aware of, uses a measure of assets as the denominator. Governments may use assets as the denominator because the losses that equity absorbs come from these assets. Moreover, the underlying data on losses and capital we use for our calculation express capital with assets in the denominator. We agree that certain liabilities pose risk to banks to the degree to which their holders can run. We believe higher equity levels make running less likely, but the thrust of our Plan is to use equity to absorb losses.
I made this comment in the third paragraph on page 4. While I largely agree with response 20, the point I was raising concerned the reality that at any given point in time, a bank may more easily know the face value of its short-term liabilities, such as deposits and wholesale funding, whereas ascertaining the value of illiquid or infrequently traded assets poses a constant and costly challenge to banks. Rather than relying on complex educated guesswork by bankers and regulators about asset values, bank capital regulations might be further simplified by getting banks to measure capital adequacy relative to short-term liabilities.
In any event, while the Federal Reserve Bank of Minneapolis’s Plan to end Too Big to Fail seems too complex, I applaud the Plan’s acknowledgement that Dodd-Frank did not address the Too Big to Fail problem, and that more reliance on equity funding offers a way to address that problem.