On May 16th, The Heller Hurwicz Economic Institute at the University of Minnesota hosted Neel Kashkari, President of the Minneapolis Federal Reserve, in a conversation on his Too-big-to-fail initiative. During the financial crisis, Mr. Kashkari ran the much-maligned TARP program, in which all banks in the US were infused with cash in an effort to “un-clog” the financial plumbing and allow markets to return to normal functioning. Mr. Kashkari was very clear that he felt the TARP program was necessary, that the Fed’s primary mistake in the crisis was that they were always reacting late, but that they were nonetheless very uncomfortable with the interventions which they felt were required. He was also very clear that the conversation he has started is intended to explore a wide range of transformational options with respect to the banking system, including breaking up the largest banks, or regulating them as public utilities, and that the Minneapolis Fed is in the process of gathering information and opinions on this topic.
Mr. Kashkari was, however, resolute in his opinion that some action needed to be taken, and that the perhaps-majority opinion at the Fed that Dodd-Frank should be allowed to work before they shake things up was not an acceptable outcome. Something needs to be done, he believes, to put an end to too-big-to-fail forever. The basic philosophy, which on its face sounds quite reasonable, is that the public should not have to risk anything to support banks, that it is inherently unfair to use public funds to protect banks’ equity holders during a crisis since banks are private, for-profit institutions.
But does this philosophy actually makes sense? What we are really concerned about is having a banking system that is able to withstand a crisis, but we do not want to be forced to rely on systemically-focused tools like providing crisis-based market support. Instead, we are determined to identify a banking structure – whether through a better mix of businesses or a higher capital requirement – that has no negative impact on the public wallet.
The underlying philosophy, in my opinion, is illogical. Let’s just focus on the capital requirement. Many theoreticians would like us to believe that higher capital requirements are costless (or even beneficial), since they result in lower debt costs and greater capacity for risk-taking by banks. This is essentially a souped-up version of Miller-Modigliani, an application of that frictionless world of firm capital structure to the entire economy. Most bankers are on the other side of this argument – they believe that higher capital requirements result in a higher overall cost of capital, which constrain a bank’s ability to lend, thereby limiting economic growth overall. A recent review of academic literature in a DNB Working paper titled Effect of bank capital requirements on economic growth: a survey, found that most empirical evidence suggests that an increase in capital costs of 100 basis points reduces lending by anywhere from 1.2 – 4.5%. While the paper was careful not to extrapolate from this to an expected impact on GDP overall, I would argue that a lending reduction of this amount spread across an entire economy would have a measurable impact on GDP. If the growth impact on our $18 trillion economy was just 10 basis points annually, over a ten year period this lower growth would cost the US Economy about $1 trillion in GDP – more than the 2008 bailout. And let us not forget that the entire amount lent under TARP was repaid, so the cost to the taxpayer is probably best summed up as the interest paid on funds borrowed.
I fully realize that in that last paragraph I am just making numbers up. My point is to simply place what seems like a modest growth impact in context with respect to the perceived unfairness of providing stability to the banking system during a crisis. There is no solution to this problem that is costless to the public, and it is entirely possible that the cost of building an unassailable fortress around the banking system is significantly greater than the cost of supporting the system in crisis.