After the financial crisis, new regulations sought to address systemic risk within the U.S. financial system, including rules addressing capital requirements, liquidity ratios and leverage levels. Even with the enactment of the Dodd-Frank Act, which has yet to be fully imposed, debate continues on whether “too big to fail” remains an issue or whether the risk to the economy has been mitigated.
Among those who still see a key problem, proposals to address the issue range widely. Symposiums held at the Minneapolis Fed explored several of these ideas. Here is a brief overview.
Some researchers, such as Simon Johnson from MIT, have suggested limiting bank size. Others, such as Anat Admati from Stanford, have suggested much higher capital requirements for large banks. A third proposal, by John Cochrane from Stanford, emphasizes changing the treatment of leverage in the tax code. A fourth proposal seeks to improve the bankruptcy laws in a way that will allow troubled financial firms to more readily go through bankruptcy. While this idea has caught attention, it is fraught with technical complications. So I will focus on the first three ideas.
Bank Size Limits: I have advocated a system with smaller financial institutions that can be allowed to fail if necessary. But size restrictions seem arbitrary. Why should a particular bank size be risky and another size not? In addition, recent evidence suggests that substantial economies of scale exist, perhaps even for the largest financial institutions. And the primary concern could be that complexity or interconnectedness is the trigger of financial fragility rather than size itself. For these reasons, some analysts have concluded that a size restriction alone may not be the most natural solution.
High Capital Requirements: Raising capital requirements for large institutions is emphasized in the Dodd-Frank Act. The idea is that higher capital requirements offer a larger buffer to absorb shocks, reducing institutions’ risk of failure. Admati argues that capital requirements should be even larger, making equity capital levels more comparable to those of nonbanks. Researchers point out that banks had much higher levels of capital in earlier eras when owners and shareholders were personally liable for paying banks’ creditors. This suggests that the market solution is to have banks hold more capital than they do today.
Comments by Fed Gov. Jerome Powell and other officials suggest that higher capital requirements may cause firms to rethink their size. Some large firms, such as GE Capital, have divested to avoid being designated as systemically important within the Dodd-Frank Act, a designation that can lead to higher capital requirements.
Leverage: Many have suggested that leverage — not capital — is the issue, in which case Cochrane’s proposal to rethink the tax treatment of leverage might be a good idea. Keep in mind the “tech” bubble in the late 1990s and early 2000s, when firms had to raise their financing through equity. Although investors lost money when the market crashed, the repercussions for the economy were not as significant as the housing bubble crash several years later. The U.S. tax system favors bond financing: Interest payments on debt instruments are tax-deductible, while dividend payments to shareholders are not. A less favorable tax treatment for bond financing and a more favorable treatment of equity financing might add stability.
These are interesting ideas, but there is also a global aspect. In particular, we have seen efforts on a global level to limit systemic risk through coordinated regulatory policies across countries. In my experience, however, other countries often seem to be less concerned about Too Big to Fail as an issue than we are in the U.S. There is sometimes a tendency to view large financial firms as national champions, deserving of protection. In part because of this, we are evolving globally toward a regulated utility model — whereby very large financial institutions are under heavy regulation, which in my view makes them unlikely to innovate effectively in the future. This may leave them vulnerable to coming waves of financial innovation. This is an additional consideration in the ongoing Too Big to Fail debate.
 |
This commentary is reprinted with permission from The Regional Economist, a publication of the Federal Reserve Bank of St. Louis, where James Bullard is president and CEO. |