Dear Neel Kashkari, Your TBTF Plan Won't Work. This One Will

This guest commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics

Dear Neel Kashkari, Your TBTF Plan Won't Work. This One Will - too big to fail images 2

Source: Jagz Mario

Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, presented his Bank’s plan for preventing too big to fail (TBTF) here. His solution is a variant of all others. Namely, regulations to limit what banks can do. In Kashkari’s case, high capital requirements for large banks, 22.5%.

Like all previous attempts to end TBTF, it is doomed to fail.

The reason is nothing can prevent financial or other economic crises and TBTF is a government decision—the government decides to bail out large firms. Why not save small firms too? The answer, of course, is that if the government saved all firms, no firm will look out for themselves—there is no downside risk! Precisely! That’s what TBTF does, it eliminates downside risks. But only for large firms, as the recent financial crisis clearly demonstrated.

Because TBTF is a government decision, it can be ended only if the government decides not to do it. If the government couldn’t rescue any firm, financial or otherwise, firms would be incentivized to take steps to minimize the likelihood of their own failure.

Solving Too Big To Fail: A Constitutional Amendment

The government could decide not to bail out any firm. But, of course, it won’t. The idea that failure of systemically important firms would have disastrous consequences is too ingrained in political decision making. This happens in spite of the fact that no one can say exactly what constitutes a systemically important firm much beyond the fact that it’s big.

There is only one sure way to end too big to fail: a constitutional amendment. Consequently, I recommend that we begin work on an amendment to the constitution that forbids the government or any agency created by congress, e.g., the Federal Reserve, from bailing out any private company or financial institution of any size, for any reason. A constitutional amendment can end too big to fail and, in so doing, end the large survive/the small fail inequity.

Some might say, “but a big firm could still fail.” Yes, that’s true. But a constitutional amendment would significantly reduce the likelihood this will happen. That no firm will be bailed out, gives all firms the incentive to be careful. Financial institutions will be incentivized to use well-known risk management techniques to limit the exposure to any one financial institution or firm. They will be incentivized to know the risks they are taking when making loans or purchasing assets.

Dear Neel Kashkari, Your TBTF Plan Won't Work. This One Will - thornton quote box

A big problem during the recent financial crisis was the fact that banks and other financial institutions held large portfolios of mortgaged-back securities (MBS) with only scant knowledge of the real assets that backed those loans. When home prices began to fall nationally, MBS became “toxic.” Financial institutions holding MBS did not know the worth of their MBS. Hence, banks became skeptical about lending to one another. Indeed, few were willing to lend to any firm holding large quantities of MBS. A constitutional amendment would ensure that firms know the real assets supporting such securities.

I am not suggesting that there should be no oversight of banks and other financial institutions. The Federal Reserve, the Federal Deposit Insurance Corporation, the Security and Exchange Commission, state agencies, and other regulatory bodies should continue their oversight as before. Instances where a financial institution is deemed to be taking on excessive risk should be dealt with promptly and decisively by the regulatory agency.

I expect to hear a variety of arguments for why this is a bad idea or that simply it won’t work. But the alternative is a volume of regulations that will continue to grow after each new crisis. The increasing number and scope of regulations will make markets and the economy ever more sclerotic while doing little or nothing to reduce the likelihood of the next financial crisis, which will neither be expected nor predicted.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.