'Too Big to Fail' Forum: Plenty of Heat, Little Light

WASHINGTON — If the debate over "too big to fail" were an international negotiation, it wouldn't be clear that the two sides of the discussion were even speaking the same language.

That was the takeaway Monday from the first public forum on the issue hosted by the Federal Reserve Bank of Minneapolis, in which prominent academics and former regulators diverged not just on how much progress had been made in reforming the system, but on how any progress should be measured.

Some put the emphasis on higher capital requirements, while others warned that too much reliance on a single metric would be a grave error. A few pointed to new, untested tools that regulators have been given since the financial crisis, but some were already prepared to declare them a failure.

Minneapolis Fed President Neel Kashkari said the purpose of the forums is to "assess the progress that has been made since 2008" and come up with possible solutions by yearend, but based on the opening salvo, consensus around these issues appears a long way off.

Kashkari, a former Treasury official in the Bush administration and a failed candidate for governor of California, couched the effort in terms of a goal most lawmakers of both parties agree on: helping small banks.

"My hope is that if we can truly address the risks posed by the large banks, then perhaps we can relax some of the burdens that small banks are facing as they are caught under the regulatory net," he said.

But many of the academics assembled for the program were more focused on how the system has changed since the financial crisis.

Anat Admati, professor of finance and economics at Stanford University, said that the regulatory reforms outlined by the 2010 Dodd-Frank Act and the Basel III accords have done little to fundamentally shift risk from the taxpayer to the banks themselves. In a slide presentation, Admati called the Dodd-Frank Title I requirement for systemically risky banks to submit "living wills" to ease bankruptcy proceedings a "charade" and said that even without seeing the most recent submissions she could tell that they would not be credible.

"I have not seen the submissions, the 10,000 pages," Admati said, "but I will give them a grade right here: fail. It is not possible to pass these tests. They don't have the information to pass it. They can't tell me the thousands of ways they can fail that won't harm" the financial system.

Admati went on to call for a drastic increase in the amount of equity capital that banks would be required to retain from roughly 5-8% under the Basel regime to between 15% and 30%, as is more common for nonbanks in Silicon Valley and in some investment firms.

She said that whereas Congress remains unwieldy and deadlocked, the Fed could set a 15% equity requirement, as was suggested by a bill put forward by Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., or reimpose a separation between commercial and investment banking, as was required in the 1933 Glass-Steagall Act. But to do that, the Federal Reserve Board would have to invoke its authority in Title II to restructure the banks by deeming their living wills "not credible." (The Fed and Federal Deposit Insurance Corp. are expected soon to release their evaluations of the most recent round of living wills.)

"The Fed is a body that can make decisions in Washington, D.C.," Admati said. "The Fed could do Brown-Vitter and Glass-Steagall and anything they want, if only they dare to fail the living wills."

Simon Johnson, a professor of entrepreneurship at MIT, agreed that many post-crisis changes will not enable the government to fail a megabank. While living wills, new capital rules and living wills might be enough to resolve smaller institutions like Countrywide or Bear Stearns, they will not be sufficient to allow the government to fail Citigroup or Bank of America, he said.

"Will [living wills] work? It's going to be tough," Johnson said. "Don't abolish it, please, but it's not going to work for the megabanks. Above 2% of GDP, it's very dangerous to allow these banks to continue in operation."

But Eugene Ludwig, founder and CEO of Promontory Financial Group and a former comptroller of the currency, said that breaking up banks as a matter of policy could actually increase systemic risks by shipping them offshore or creating costs for the U.S. economy.

"No one can answer this question right now with any reasonable amount of certainty one way or the other, and the costs of acting wrongly are profound," Ludwig said. "Acting on a hunch here and breaking up large banks or artificially limiting their size is not the right answer."

Til Schuermann, a former senior vice president of the New York Fed and partner with the consulting firm Oliver Wyman, agreed that more equity capital insulates a bank from downside market risks, but took exception to the levels of capital called for by Admati. Citing the results from last year's stress tests, Schuermann said that even in scenarios of financial stress far in excess of what the banking system endured in 2008, all the largest and most systemically risky banks emerged with ample capital.

"The capital depletion due to the stress test … ate up about $380 billion, and that's according to the Fed calculation," Schuermann said. "After the stress scenario, just these 31 banks had as much capital … as the entire banking system had back in 2006."

Randall Krozner, a professor of economics at the University of Chicago Booth School of Business and a former Fed governor, similarly criticized the emphasis place on the supposedly low levels of capital retention. Likening capital rules to the pre-World War II French defense strategy of fortifying the frontier with Germany as an adequate guarantee of French sovereignty, Krozner said that relying on ever-higher capital might give the public an unrealistic sense of safety.

"Even if you have 100% capital, it is possible to fail," Krozner said. "We don't want to focus too much on any one instrument."

Others took a different approach.

Deborah Lucas, a professor of finance at the Massachusetts Institute of Technology, said that an emphasis on "ending too big to fail" may be the wrong approach. Instead, she said, policymakers need to identify the extent of a firm's implicit or explicit reliance on federal guarantees and tax that firm commensurately.

"There are always going to be guarantees, explicit or implicit," Lucas said. "So the question is, should we be thinking about some kind of 'too big to fail' guarantee fee, both to compensate taxpayers … but also as a way to encourage downside risk."

The debate within the forum reflected a broader battle that wages outside of it.

Several representatives of the banking industry — especially the largest banks — issued public statements leading up to the forum criticizing the Minneapolis Fed and Kashkari for pushing what it viewed as a biased agenda that ignores the progress that has been made since 2008. Tony Fratto, partner with Hamilton Place Strategies and another former Bush administration official, said he welcomes serious debate on financial regulation, but that the tone of the Minneapolis Fed forum assumes that no progress has been made, which is unfair.

"While Kashkari was off doing other things, serious policymakers and regulators around the world were doing the difficult and complex work to make the global financial system safe and sound," Fratto said. "To parachute in at the end of this eight-year process and drop bombs with hashtags isn't serious." (The Minneapolis Fed has encouraged participants and viewers to use the #EndingTBTF hashtag.)

John Dearie, acting CEO of the Financial Services Forum, similarly criticized Kashkari's event as tangential to the Minneapolis Fed's mandate and seemed to suggest that the event had a political rather than public interest motivation.

"Since he left government to enter politics, it seems Mr. Kashkari hasn't kept up to date with the many ways in which U.S.-based global financial companies have become simpler, stronger, and more streamlined to serve their customers and clients and drive the real economy," Dearie said. "Since none of those financial institutions are within the jurisdiction of the Minneapolis Federal Reserve Bank, it isn't clear why this is his area of interest now, but hopefully some of the progress that has been made will be discussed today in Minneapolis."

Tim Pawlenty, the former Minnesota governor and now CEO of the Financial Services Roundtable, said he welcomed the debate and hopes to offer assistance in forwarding "wise and informed" conclusions, but noted that "America needs banks of all sizes to be competitive."

During the forum, Adam Posen, president of the Peterson Institute for International Economics, cast doubt on the post-Dodd-Frank regulatory regime in a number of areas. Posen said the capital rules are important but far from the only concern facing regulators, whereas issues like so-called "total loss absorbing capacity" rules — which he criticized as "too clever by half" — and living wills are flawed attempts to quantify and institute safety and soundness worldwide. A more fruitful approach might be to simply focus on and limit high-risk activities wherever they may be found, Posen said.

In a more general sense, he said, the approaches forwarded thus far at the event have tended to avoid the simple fact that the 2008 crisis was precipitated, at best, by inappropriate interpretations of longstanding banking rules and regulators' willingness to look the other way.

"It's not about, 'We don't know what the externality is.' It's about how the right regulations are not properly enforced or are obfuscated or hid, and people are not properly punished and held responsible for that when it is done," Posen said. "There is no reading of bank regulation that says, 'You should be making fraudulent loans and hiding things in AIG financial products or the JPMorgan whale,' but we did that. Don't make this about something abstract when it's something in reality."