This week, Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, updated us on his Ending Too Big to Fail (TBTF) initiative.

Update or U-turn?

The update is remarkable. Neel has dramatically lowered his ambitions. I now really wonder if Neel will push ahead.

Neel’s first speech on ending TBTF, given on February 16, considers at least three options, bold and transformational:

• Breaking up large banks into smaller, less connected, less important entities.
• Turning large banks into public utilities.
• Taxing leverage throughout the financial system.

In addition, in the Wall Street Journal, Neel advanced the idea of requiring banks to hold at least 25% of capital over total assets: “I’ve seen some proposals for a 25% capital requirement.  So leverage ratios, effectively, just to keep it simple, you know, 4:1.”

When I read Neel’s ideas in February, I thought it was great! Especially given that BOE’s Mark Carney informed us that the era of too-big-to-fail was drawing to a close and the rest of Europe had given up on increasing capital requirements.

Things started falling through the cracks soon after. On April 18, Neel gave an update where he struggles with the idea of breaking up banks. Referring to an earlier TBTF seminar he notices: “Discussants also expressed doubts about how easy it would be to actually implement a “break-up” plan … . An image of government analysts arbitrarily deciding how to divide a trillion-dollar bank into smaller pieces, … gives many people concern—including me.”

Instead of breaking up big banks, Neel suggests to let time do its work. This in combination with higher capital requirements. Over time, large banks will respond to higher capital requirements by eliminating assets with low returns: “I believe that given sufficient incentive, banks would be able to restructure themselves.”

The April speech does not any longer mention the idea of turning banks into utilities. By that time we are left with i) the debt tax initiative, and ii) the higher capital requirements initiative.

So far so good.

The end of the end of TBTF?

The June Update on Ending Too Big to Fail is hardly an update. The front-end looks as ambitious as the February speech. Unfortunately, many of the mantras look cry-wolf to me: “we need massive structural changes in the financial system” and “we must act now to address TBTF”. (Emphasis added.)

Two points that Neel raises are remarkable. First, in this speech Neel pays attention to the shadow-banking sector. He is mindful that the burden of post-GFC regulation will incentivise the financial sector to move business to an ominous, less regulated part of the financial world. I struggle with the alleged threat of the shadow banking sector. If this was a threat to worry about, then why do regulators worry about it after the completion of major regulatory initiatives, such as Basel III?

More worryingly, a reference to the shadow banking sector may also indicate a willingness to help banks to keep their business.

The second remarkable point in Neel’s speech is the attention he devotes to bail-in, and how it would not work in practice. Though previous speeches showed skepticism about bail-in, this one dedicates about a third of the allocated word-count to bashing bail-in.

Agreed, I am skeptical about bail-in too. But I would require banks to have more equity in issue to lower the probability of default.

Neel, however, chooses to put his transformational plans for higher capital requirements on the back-burner: “More capital has downsides that need further exploration. In particular, higher capital could raise the cost of lending and potentially reduce economic activity.”

Amazing. Despite ample evidence1 that contradicts Neel’s caution about higher capital requirements, he just lowered his leverage ratio ambitions from 25% in February to 5% in June. In about 4 months time he relaxed his ambition by 16 basis point per day.

Is bailout back?

We are now left with the debt tax initiative … and bailout apparently, as bail-in won’t work. But, taxes are likely outside Neel’s remit as this is something for the OECD and G20 to sort out via, e.g. via the Base Erosion and Profit Shifting initiative.

Why worry about TBTF?

Though Neel worries about TBTF, I think it is a symptom of something else not being right. For example, Calomiris and Harber show that the U.S. banking system is inherently populist, sensitive to the interests of politicians, farmers, home-owners. Other research may show that the U.S. supervision arrangements are flawed. Addressing these underlying factors may be more effective than trying to end TBTF. In addition, there are other TBTF industries that hardly worry us as intensively. Take a look at European car manufacturing, an industry that kills people through toxic exhaust fumes.

Why Neel?

I wondered why Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, worries about TBTF. Are the banks in his district too big to fail and poorly capitalised?

To find out, I downloaded data on U.S. bank holding companies. I then measured the maximum bank size per district (measured in $Tn total assets, BHCK2170), and the average capitalisation – measured as Tier 1 Leverage ratio (BHCA7204) on 31/12/2015.

The graphs below show max size and average capitalisation of banks per district. See for yourself:

Size: Maximum Total Assets in $Tn, per district.

Average Tier 1 Leverage ratio in %, per district.

Reference:

1. There are reams of papers that support higher capital requirements, see for example work by Anat Admati, and this recent BIS paper http://www.bis.org/publ/work558.pdf