Kashkari: Higher Capital Is Better Remedy than TLAC

WASHINGTON — Two weeks after holding the first in a series of symposia on the state of "too big to fail," Minneapolis Federal Reserve President Neel Kashkari said he still has doubts about the workability of bail-in rules and resilience of the largest banks.

In a speech prepared for Monday in Minneapolis, Kashkari said he was unsure whether post-crisis reforms for the biggest banks "go far enough." He focused particularly on a plan requiring behemoths to hold enough unsecured debt in order to recapitalize a failed bank. Under the Federal Reserve Board's proposed "total loss absorbing capacity" rule, unsecured debt would be converted into equity in a successor bank — essentially acting like a built-in bailout to avoid the need for taxpayer funds.

TLAC "has not worked in practice in prior cases, and I doubt it will work in the future," Kashkari said in remarks prepared for the Minnesota Chamber of Commerce.

Although unsecured creditors could have an equity piece in a TLAC scenario, Kashkari said, he argued that regulators may resist imposing haircuts on creditors out of concern for the reputational risk to a new company emerging from a government resolution.

Kashkari said policymakers faced similar complications in the crisis when it came to whether the government should haircut creditors to the government-sponsored enterprises. Similarly, even banks themselves could have let their legally independent "structured investment vehicles" fail during the crisis, but they preserved them for fear of the effect on the banks' reputations.

"During the crisis, some banks chose to rescue their SIVs because of reputational risks they would incur if they had allowed the SIVs to collapse," Kashkari said. "The SIVs' liabilities became the sponsoring banks' liabilities. During the crisis, reputational risk broke through what had appeared to be a strong legal firewall."

Kashkari lauded certain reforms and implementing regulations developed after the crisis that, he said, are "headed in the right direction, particularly those that make banks stronger with additional capital, deeper liquidity and stress testing."

But similar to the April 4 symposium, as well as a much-publicized speech in February, Kashkari continued to press for much tougher reforms to end too big to fail. At the symposium, he had joined others in calling for greater equity capital held by the largest banks as well as steps to break up the largest institutions.

He said higher capital requirements would avoid the implementation challenges posed by TLAC by making the banks less likely to fail in the first instance, and would have the added benefit of being simple to understand and implement.

"There is a strong argument that simpler solutions are more likely to be effective than complex ones, so I see virtue in focusing on increasing common equity to assets, which seems the simplest and potentially the most powerful in terms of safety and soundness," Kashkari said. "We have to be prepared for more change. More capital will absorb losses even from activities we cannot anticipate today."

With respect to breaking up the largest banks, Kashkari noted the challenges voiced during the symposium — for example, whether a series of smaller banks would not be as risky as a single very large bank; whether the economies of scale that benefit big banks also benefit smaller banks and the economy at large; and how exactly such a program were to be implemented in a way that was not harmful.

He said post-crisis reforms are already spurring banks and other financial firms to rethink their size and complexity even without a formal breakup plan by regulators, so further restrictions and costs associated with size could simply hasten that process.

"New requirements, put in place after the financial crisis, have already encouraged some large financial institutions to shed some operations and assets," Kashkari said. "While the magnitude and speed of their spinoffs may not satisfy financial stability concerns, they do demonstrate firms' ability to downsize in response to new requirements. I believe that given sufficient incentive, banks would be able to restructure themselves."

Kashkari, a former Treasury Department official who oversaw the Troubled Asset Relief Program and later ran for governor of California as a Republican in 2014, stunned the industry in the February speech — his first since taking the helm of the Minneapolis Fed — by staking out the position that the largest banks were still too big to fail and needed to be broken up or turned into financial utilities.

Since that speech, the Minneapolis Fed has undertaken a series of symposia to review the issue, with the next scheduled to be held on May 16. Federal Reserve Board Chair Janet Yellen said April 7 that she does not agree with Kashkari's negative view of the post-crisis reforms, but defended his prerogative to pursue the issue. The Minneapolis Fed is expected to produce a white paper of recommendations to the board by year-end.