Neel Kashkari: How to fix the banks | The Economist

[Neel Kashkari, head of Minneapolis Fed] is an experienced financial firefighter. An alumnus of Goldman Sachs, best-connected of investment banks, he spent much of 2008 and 2009 in the Treasury department overseeing the Troubled Asset Relief Programme, under which the American government bought more than $400bn of toxic assets to prop up teetering financial institutions. In 2014 he ran to become governor of California as a Republican. He now says that, despite the efforts of regulators since the crisis, much more needs to be done to avoid future bail-outs of banks that are “too big to fail”.

Using an IMF database, the Minneapolis Fed logged the levels of bank capital that would have been needed to avert 28 financial crises in rich countries between 1970 and 2011. Based on the historical relationship between capital levels and crises, Mr Kashkari says there is a 67% chance of a bank bail-out at some point in the next century. This is despite significant new capital requirements imposed since the financial crisis which have, he says, brought down the chance of a failure from 84%.

His solution is to force banks to finance themselves with capital totalling 23.5% of their risk-weighted assets, or 15% of their balance-sheets without adjusting for risk (the “leverage ratio”). This, says Mr Kashkari, would be enough to guard the financial system against a shock striking many reasonably-sized banks at once. Any bank deemed too big to fail would need a still bigger buffer, eventually reaching an eye-watering 38% of risk-weighted assets. Such a high requirement would, in effect, force big banks to break themselves up.

This is radical stuff. Under “Dodd-Frank”, the law that overhauled financial regulation after the crisis, the minimum leverage ratio for big banks is only 6%. But Mr Kashkari’s numbers should be treated with caution. For a start, he counts only common equity, the strictest possible definition of capital, and ignores everything else, such as debt that converts into equity in times of crisis. Recent new regulations aim to ensure that the “total loss-absorbing capacity” of the largest banks, which includes such instruments, reaches at least 18%. Mr Kashkari’s main complaint is that he does not think complex safety buffers will actually work in a crisis.

Much higher capital requirements could put some banks, a few of which are already worth less than the book value of their assets, out of business. Not my problem, says Mr Kashkari, who argues that it is banks’ responsibility to find profitable and safe business models.

Source: Kash call | The Economist

Wait for the push-back from big banks. But their tactics will mainly be scare-mongering to protect profits (and bonuses) by dissuading politicians from acting on an eminently sensible proposal.

Banks need to be bullet-proof and not rely on the taxpayer’s dollar to bail them out in times of crisis. Australian banks, with leverage ratios as low as 3%, are entirely dependent on taxpayer rescue in times of crisis.

Fractional-reserve banking is not a fundamental building block of capitalism (some would call it an aberration). Countries like Germany funded their industrialization without it, their early banks being entirely equity-funded. Fractional-reserve systems are characterized by frequent boom-bust cycles, while banking systems with higher equity funding are far more secure and less likely to spread contagion through the entire economy if they default.