Banks Are Still Too Big to Fail. So What's to Be Done?

02_19_neel_kashkari_01
Minneapolis Fed President Neel Kashkari speaks during an interview at Reuters in New York City on February 17. The risk of another financial Armageddon remains a real and present danger, and Kashkari has a plan. Brendan McDermid/Reuters

This article first appeared on the American Enterprise Institute site.

New Minneapolis Fed boss—and Troubled Asset Relief Program (TARP) boss during the George W. Bush administration—Neel Kashkari gave a blockbuster speech on February 16.

Despite Dodd-Frank financial reform, Kashkari said he believes "the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy." What's more, he's eventually going to present a plan to end Too Big to Fail (TBTF) once and for all. But not just yet.

Starting in the spring, the bank is going to hold some symposiums, issue some policy briefs, gather some feedback and then assemble a plan. But Kashkari did offer some policy options during his speech. And they're biggies:

  • Break up large banks into smaller, less connected, less important entities;
  • Turn large banks into public utilities by forcing them to hold so much capital that they virtually can't fail (with regulation akin to that of a nuclear power plant); and
  • Tax leverage throughout the financial system to reduce systemic risks wherever they lie.

Kashkari said he wants "transformational measures," and these would seem to qualify. They have already transformed the debate, reigniting conversation about next-gen financial reform among policymakers, industry and activists.

Just as interesting is his take on where we currently stand, post-Dodd-Frank. He outlined two scenarios. First, an individual megabank gets into trouble during a time of economic stability. Second, one or more megabanks run into trouble during a time of economic weakness or crisis.

My assessment of these tools under the first scenario is that they do have the potential to deal with the failure of a single large financial institution without requiring a bailout or triggering widespread economic damage. But we don't know that for certain, and the work on these tools is incomplete and slow-moving.

For example, reviews of the largest banks' living wills find that they have significant shortcomings, with the government requiring the banks to try once again to make themselves able to fail without massive fallout.

Until this work is complete, which could be years from now, we must acknowledge that the largest banks are still too big to fail. And even then, we won't know how effective these tools are until we have actually used them.

Unfortunately, I am far more skeptical that these tools will be useful to policymakers in the second scenario of a stressed economic environment.

Given the massive externalities on Main Street of large bank failures in terms of lost jobs, lost income and lost wealth, no rational policymaker would risk restructuring large firms and forcing losses on creditors and counterparties using the new tools in a risky environment, let alone in a crisis environment like we experienced in 2008.

They will be forced to bail out failing institutions—as we were. We were even forced to support large bank mergers, which helped stabilize the immediate crisis, but that we knew would make TBTF worse in the long term. The risks to the U.S. economy and the American people were simply too great not to do whatever we could to prevent a financial collapse.

So in the first case, he doubts the efficacy of our new financial tools. In the second, he doubts the will and efficacy our institutions.

The second scenario is particularly important to consider since it counters the "let them all go bankrupt" view on the right. That's just not a realistic response. The goal of policy should be preventative. The idea of very large capital cushions has some appeal to me, but I will be closely watching what Kashkari and his team come up with.

Let me end with this: Believers in free enterprise and competitive capitalism need to understand the incredible damage that deep recessions and financial crises do to public confidence in markets and market-based policy solutions. That was certainly the case after the Great Depression, and so too the Great Recession.

Just look where the energy in the Democratic and Republican parties is right now—two candidates, Bernie Sanders and Donald Trump, who don't seem to have much respect for economic freedom. I would hate to think what U.S. politics will look like if we fall into another recession anytime soon.

James Pethokoukis is a columnist and blogger at the American Enterprise Institute.