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Interview with Minneapolis Fed President Neel Kashkari
In the latest episode of his podcast Macro Musings, David Beckworth interviews Neel Kashkari, President and Chief Executive Officer, and Ron Feldman, Vice President and Chief Operating Officer of the Federal Reserve Bank of Minneapolis.
Beckworth, Kashkari, and Feldman discuss the Minneapolis Fed’s “Plan to End Too Big to Fail” as well as improving Fed transparency and monetary policy.
Mercatus Center Senior Research Fellow Stephen Matteo Miller offered his own view of the Minneapolis Fed's plan in January.
The interview’s transcript is below:
David Beckworth: Our guests today are Neel Kashkari and Ron Feldman. Neel is the president of the Minneapolis Federal Reserve Bank, and Ron is its first vice president and chief operating officer. Under their leadership, the Minneapolis Fed has spent the past few years working on a plan to end the too-big-to-fail problem. It is called the Minneapolis Plan, and its final version was finally released.
Today, Neel and Ron join us to talk about the Minneapolis Plan as well as monetary policy. Neel and Ron, welcome to the show.
Neel Kashkari: Thank you. Thanks for having us.
Ron Feldman: Yeah, great to be here.
Background to the Minneapolis Plan
David: Neel, I want to begin with you. Can you give us the overview of the Minneapolis Plan?
Neel: Sure. When we started this initiative two years ago, we started by asking, “Have we really address[ed] a problem with too big to fail, or are the banks still too big to fail and taxpayers still at risk?” We convened the best experts in the world to give us their thoughts and brought that together in developing our plan.
The short answer is the biggest banks are still too big to fail. If they ran into trouble like in 2008, taxpayers would have to step in and bail them out. We don’t think that’s acceptable.
The best way to address that is to make the banks issue a lot more equity capital, which is the buffer they hold to protect taxpayers in case of their own economic trouble. Basically, our analysis says that the biggest banks need about double the equity that they have today.
If they did that, that would more or less address the “too big to fail” problem. Now, the plan has many detailed components: increasing the capital requirements, forcing the treasury secretary to certify that the banks are no longer too big to fail, addressing risks in the shadow banking sector, and also reducing regulations in community banks.
If I were to boil it down, the biggest dozen or so banks in America need to have at least double the equity that they have today. If we did that, that would improve the outcome for society and protect taxpayers.
David: Great. What’s the story behind the Minneapolis Plan? I know Ron wrote a book early on—early 2004 I believe—on this topic, but you also worked with TARP. How did this idea come together at the Minneapolis Fed?
Neel: I think you touched on it. Ron felt . . . and one of my predecessors, Gary Stern, wrote the original book, Too Big to Fail, in advance of the financial crisis, saying that the biggest banks are too big and the taxpayers are going to be on the hook. And they were exactly right. In my role during the financial crisis, I was at Treasury overseeing the TARP, the Troubled Asset Relief Program, where we used taxpayer money to bail out the banks.
That experience has burned into me. So Ron and I come in together at the Minneapolis Fed. We put our own experiences together, talked to other experts here in the bank and around the world, and that really drove this work that we’ve done, culminating in the release of our new plan.
David: Recently on Twitter, I saw that you had mentioned you read Jesse Eisinger’s book about the lack of prosecution for these executives at the big financial banks. How does that play into the story you’re telling, if it does at all?
Neel: The title of that book, which I find amusing, is The Chickenshit Club. That’s why prosecutors are afraid to prosecute the big bank CEOs and executives. I think it plays into it because it adds to the lack of trust that Americans feel today.
When I look at the political divide in our country, a lot of it, in my opinion, comes back to the financial crisis—the fact that, as a society, we’ve been taught that if you take a risk, you get the upside, but you also bear the consequences.
When the big banks got into trouble and we had to use taxpayer resources, that violated the fairness principle. The American people didn’t cause this mess, but it was their money that had to go in to stabilize it.
Then, to add on top of that the fact that it seems like senior executives who were in charge of institutions that got into trouble did not really face real consequences themselves—I think it magnifies the loss of trust that the American people feel about our economic system today.
David: I share your view. In fact, we’ve had him on the show. One of the takeaways I got from the book, though, was that the regulators failed as much these executives did—the Department of Justice, the SEC.
One question I have, related to what you’re proposing: do you worry that some of the failures of the regulators—the government officials who were supposed to implement what regulations did exist prior to the crisis—that there still might be an issue even if your plan was passed?
Neel: Actually, our plan is designed to assume that regulators are going to screw up in the future. Regulators are imperfect, the way we all are, and we always seem to miss future financial crises. Financial crises have existed in all of recorded human history, and they will in the future.
So let’s start by assuming regulators are going to miss it. What do we need to do to make sure the financial system is strong so that the banks can have enough capital, so the taxpayers are not on the hook when the banks and the regulators miss it? That’s actually what’s motivating this plan.
David: Very nice. I like that angle because it is a very sobering read, Jesse’s book. Again, I mention to our listeners, we’ve had him on a previous episode.
What is the next step? You have this plan. You’ve spent a lot of time working on it. You mention in the report that you believe it needs to be implemented by Congress. Are you pitching it to Congress?
Neel: I’ve met with many representatives, Senate and House, Republican and Democrat. Almost everyone I meet with agrees that the biggest banks are too big to fail. We need to address it, and we need to relax regulations on community banks.
So I feel like there’s a broad consensus around the central thrust of the Minneapolis Plan. Now, just because everybody agrees with an issue—or most people agree—does not necessarily mean they’re actually going to take action. We know the political winds are blowing against us right now, and the Federal Reserve does not lobby. We’re not allowed to lobby. It’s not appropriate for us to lobby.
So what we’re trying to do is arm legislators with the best analysis available so that they can make the best possible decisions. Whether they take action now or at some point in the future, we want to make sure that this analysis is there and available to support them when the time is right.
David: Congress is the best solution, but I’m wondering if there’s anything you could do through the Federal Reserve System itself since the Fed is one of the biggest regulators. Is there any discussion you’re having with other Federal Reserve officials, any talk of maybe trying to raise capital levels through Fed regulation?
Neel: It’s something that I talk about quite a bit. There’s a wide range of opinions within the Federal Reserve System, so I’m not in a position to predict what the Federal Reserve System will do going forward, but I do think it’s important for Congress to act.
When I look at Dodd-Frank, the fundamental tenet of Dodd-Frank was “Do not change. Do not restructure the financial system.” I don’t agree with that fundamental tenet, but I understand why Congress came to that conclusion in 2010 because they were still challenged with the Great Recession. People were afraid of doing anything too dramatic to the financial system at that time.
The Fed is implementing regulations that Congress has built the framework around. That’s why I think now is the right time. The economy’s much stronger than it was in 2010. Now is the right time to go further to address “too big to fail” once and for all before we forget how painful the actual crisis was.
David: It’ll be interesting to see how that goes. It does seem—at least my impression is that both the Left and the Right understand the key argument of your plan is that there needs to be higher levels of capital funding for banks. People disagree on the details and the plans, but I think most people appreciate that point. Is that your sense as well?
Neel: I do think so, yes. And it’s very simple. The analogy that I use—when my wife and I moved to Minnesota a couple of years ago, we bought a house. The bank made us put 20 percent down on our house.
The reason we had to put 20 percent down was to protect the bank in case we ran into financial trouble. It’s simple. If we make the biggest banks put around 20 percent down on their own investments, we can protect taxpayers. It’s not more complicated than that.
The Low Inflation Puzzle
David: We’ll come back to the Minneapolis Plan in a few minutes. I want to discuss it with Ron in more detail, but I want to move on while I still have you and talk about monetary policy.
You’re a very colorful individual. For those of us who follow the FOMC, I’m a part of FOMC Twitter. I love reading your tweets. I love the fact that you have a Medium blog post. I love the increased transparency. Maybe it’s confirmation bias, but I like your views as well.
But with that said, I’m dying to ask you: What is your take on the persistently low inflation? It’s been below the 2 percent target for some time. A lot of Fed officials have been puzzled by it. There’s mysteries. There’s the conundrum, lots of articles with this Bill Wiedemann story being told. What is your take on what’s happening?
Neel: I agree with your characterization. There are lots of explanations and a lot of head scratching. If I had to boil it down into one factor that I think is probably most important, it’s inflation expectations are lower than we appreciate, and that’s the Fed’s own doing.
We’ve learned over the last 30 years how important the role of expectations are in shaping inflation outcomes. For the last five or six years, in my opinion, the FOMC has been treating our 2 percent inflation target as a ceiling.
Every time inflation starts looking like it’s creeping up, the Fed is there to run and say, “No, we’re going to keep inflation in check.” So the Fed’s own actions have been leading to a hardening of inflation expectations at somewhat below 2 percent. That then results in actual inflation being below our 2 percent target, so it’s of our own making.
David: That’s why you want to be more cautious moving forward with the rate hikes, which makes complete sense to me. The Atlanta Fed did a survey I found interesting of small businesses. This survey disclosed that the small businesses viewed 2 percent as a ceiling, not as some average point.
Let me take that point and move to a conversation that’s been had a lot lately; that is this idea of getting a new framework for monetary policy. There’s been a lot of recent conferences—the Brookings Institution, the Peterson Institute for International Economics. I was at the American Economic Association. There was a nice session there on the future of monetary policy.
There’s been a lot of discussion about a new framework, a new, maybe, approach to monetary policy. Some of the examples that have been laid out—a higher inflation target or maybe just the same inflation target but have a 1 to 3 percent range so there’s no asymmetry.
There’s also discussion of a price level target. Ben Bernanke suggested one recently. Then my personal favorite is nominal GDP level targeting. I’d love to hear what are your thoughts on these discussions?
Neel: I think the discussions are interesting intellectual and academic arguments, but I don’t think they’re very realistic. When I travel around my district and I talk about the Fed’s current framework, I get a lot of pushback on our 2 percent target. I can only imagine the outcry if we were to try to raise it to 3 percent or 4 percent, number one.
Number two, so far, we can’t even hit our 2 percent target. If we announced a higher target, 3 percent or 4 percent, or a base-level target, it isn’t obvious to me why anybody would believe us or should believe us.
David: That’s a fair point. You need credibility for the current target before you go on to the next one. Frederic Mishkin, at this most recent conference—I believe it was at the Brookings—he suggested, “Look, let’s stick with our target, but let’s make it credible. Let’s set, maybe, a range around it, so we’re not afraid to overshoot sometimes, as well as undershoot. First, get the one we have credible before we move on.”
Here’s the thought I had. I wonder if Fed officials, maybe unconsciously, maybe consciously, are worried about going above, too. They’re afraid they’ll be grilled by Congress, by the public if you came out and explicitly said, “Hey, we’re going to go anywhere between 1 and 3.” So you create the expectation that it’s OK to get 2.5, 2.4, that there’s going to be some give and take.
If you just set the barriers on the road between 1 and 3, do you think that would help?
Neel: Maybe. Nobody that I know of who’s advocating for interest rate increases is pointing to that as their reasoning. They’re saying things like, “Look, the unemployment rate is getting too low, and I’m getting nervous.”
I don’t see how a too-low unemployment rate is not equally a problem in a 3 or 4 percent inflation target.
David: Let me move on to another issue that’s hot at the Fed right now, a hot topic. That is the balance sheet reduction. The FOMC’s been very clear. I think it’s been very careful and clear in designating what it’s going to do. I think that’s great. You guys signaled well in advance, so there was no temper tantrum this time. Excellent job.
But one thing that’s been left unclear is where it will end up. And where it ends up, of course, has implications for whether the Fed ultimately sticks with its floor system, or it moves to more like a corridor system, like Canada has.
Do you have any preferences or views on that topic?
Neel: I think we haven’t decided yet how small a balance sheet we want to return to. I think there are advantages to both a corridor system and a floor system. Obviously, the Fed had a corridor system for most of its history, up until recently, when we adopted the floor system around QE. We think, on the margin, a floor system is somewhat easier in terms of operational complexity, a little lower complexity.
I also see an advantage that, if we are in a low r-star environment, where we could be hitting the zero lower bound more frequently, and we might have to turn to QE in future downturns, then if we’re already in the floor system, admittedly with a smaller balance sheet, maybe it’s somewhat easier to then ramp up QE, as opposed to having to shift from a corridor system to a floor system in the future.
So on the margin, I think there are some benefits to a floor system, but I see advantages both ways.
Neel’s Use of Medium and Fed Transparency
David: In the last few minutes I have with you, I’ve got to ask about your use of Medium to explain your FOMC decisions. It’s been a refreshing change to have an FOMC official come out and explain why they did what they did.
Also, using Medium is hip. You’ve definitely reached the millennial generation. How did you come about using Medium and thinking about explaining your decision on it?
Neel: It’s something I’ve wrestled with because there’s always a desire for more transparency. People want to understand our decision-making. At the same time, people criticize the Fed, saying there are too many Fed speakers. There’s a cacophony of views, and it just adds to noise and confusion.
So I was trying to think of a way to enhance transparency without adding noise, and what I came up with was, after I cast a vote, let me explain—looking backwards—here’s the data and analysis I looked at to reach my conclusion.
It was a way to enhance transparency. But because it’s backward-looking entirely, it shouldn’t add any noise looking forward. I feel like it’s doing that. I’ve gotten a lot of good feedback that my Medium posts are transparent and very clear. They’re also not adding noise. I’m happy about that and hope to keep it up.
David: At the FOMC, do you get feedback from your fellow members there, like, “Hey, that’s a great idea. Maybe I should try it.”
Neel: I’m trying to lead by example, but leading by example implies that somebody’s following. I haven’t seen others come out, either on Twitter or their own Medium posts, explaining their votes on the FOMC. Not yet, but I’m hopeful in the future.
David: That would be great. I think it’s very insightful. It’s useful. I appreciate your engagement on Twitter because I know a lot of times, you get flak from people who believe the Fed is out to destroy the world, or the Fed’s artificially lowering rates, or the Fed is the reason for all the bubbles.
You patiently engage, which is amazing. Appreciate all that you’re doing and putting a refreshing new face on the FOMC.
Neel: Thank you. I appreciate that, and thank you very much for having me.
The Moral Hazard Problem
David: Thank you.
I want to move to Ron. I want to talk a little bit more about the Minneapolis Plan. Let’s begin by asking this question, Ron, since you have a whole book on this from 2004 you wrote with Gary Stern, Too Big to Fail: The Hazards of Bank Bailouts.
How did we get to this place to begin with? How did we get to a “too big to fail” that seems to be persistent to our banking system?
Ron: That’s a good question. Maybe I’ll take a step back, David, and try to think a little bit about what do we mean when we say “too big to fail”? There’s been even a bit of an evolution in my thinking over the last 20 years that I’ve worked on this issue.
Historically, what was the problem? What were people concerned about? People were concerned that, because the government was both explicitly, through things like deposit insurance, but also implicitly, were protecting the creditors of large banks. The concern was that these creditors, who normally would be trying to price the riskiness of a bank, no longer had that incentive because they were going to be protected no matter what.
What people were worried about is the classic moral hazard problem. If there’s not pricing of risk at banks, banks don’t get the right signals about how much risk they’re taking. They take on more risk than they would otherwise, and then they end up getting in trouble and getting bailed out.
When you think about it in that framework, the problem isn’t really so much the bailout. The problem is all the prior decisions that banks made that were basically poor uses of resources. That was the problem that people at Minneapolis Fed were worried about, and before I got here, too. They’ve been worried about that for years and years. That was the “too big to fail” problem.
Again, the problem is, we need to not protect these creditors because then they’ll give the right signals. Then banks will take on less risk. They won’t get bailed out. But more importantly, you won’t have thousands of thousands of, let’s say, multifamily apartment buildings standing vacant in Miami, or something like that.
That’s one definition of the problem. Then there’s a second definition that people have, which is . . . let me say, these two camps sometimes would argue with each other. The first camp, sometimes people would call these moral hazard absolutists, or some things like that.
The second camp says, “Look, that’s not the problem. The problem isn’t that bankers are going out there and taking on more risks only because they wouldn’t do it if they had to pay 4 percent on their bonds, but instead, they’re paying 2 percent on the bonds, and so that’s the problem.”
They’re saying the problem is a classic externality problem. If I’m running a big bank, I don’t think about what happens when my bank fails. When my bank fails, that can lead other banks to fail, and it can lead corporations to not get funding. The end results is a reduction in GDP.
So the problem is this externality, and what we need to do is try to figure out how to price in that externality. Then banks can operate in a more effective way. They’re not worried about, necessarily, this moral hazard issue. They’re just worried about the problem being banks are going to get too big, too complicated, or whatever it is. When they fail, they’re worried about the spillovers that are going to occur.
Anyway, those are the issues. How did we get there?
One view is that we got there because the government was guaranteeing stuff. The other view was, “Well, no, what happened was firms just got more complicated over time. They got bigger over time. And when they got into trouble, there was more of a ripple effect on everybody else.”
B.oth sides basically propose almost the exact same kind of reforms.
That’s how we got to the current situation, where banks got more complicated. Because they got more complicated, people were worried about them getting in trouble. Because when they got into trouble, that led to big problems, they got bailed out. So you could say that both sides were half right.
David: That’s interesting. You have the moral hazard absolutists, and then you’ve got the spillover story from having a large institution. It seems like those two could be interconnected, right?
Ron: Yeah, in fact, in the book, we tried to argue that they were basically connected. The way we said it was, why do policymakers want to bail out banks? There’s different views. Some people view it as political economy. They’re trying to help their friends. Some people have got that take on it.
Our take was, if you’re a policymaker, and you are worried that if a large bank fails, other banks are going to fail, and we’re going to basically have another Great Depression on your hand, or a Great Recession on your hand, you’re going to try to engage and prevent it.
That’s the connection. Since people know you’re going to do that, then they know that they’re going to get protected. Therefore, they’ve got an incentive to take on too much risk. So in our minds, they’re interrelated.
What’s my point in bringing up some history here? It doesn’t really matter if you think there’s a lot of moral hazard or not. You’re going to end up making the same recommendations as if you did think it was a lot of moral hazard.
David: Just to be clear, what I had in mind is that you have the moral hazard story, which there may be some truth to it. Is there any evidence that that has encouraged banks to get bigger? Not just to take on more risk, but to expand?
Let me phrase the question this way. Why have banks become so large and so concentrated, outside of a moral hazard story?
Ron: There’s a scale story that some people have, which is, if you think about credit card lending, or if you think about asset management, or if you think about even consumer lending, a lot of that business is really getting a computer, programming the computer, and then taking advantages of the scale that you have in managing those accounts.
That would lead firms to get bigger, separate from everything else. In fact, the question is whether the very, very large banks in the US, are they at scale or way off the scale? I think there’s a reasonable debate about whether banks that big are excluded scale, or whether it would get exploited at a much smaller scale.
Why Higher Capital Requirements
David: Let me move on and talk about your capital requirements. The Minneapolis Plan calls for capital or common equity being at the level of 23.5 percent. Explain that to our listeners. What does that mean?
Ron: We would require banks to fund themselves with equity that would be equal to 23.5 percent of their risk-weighted assets. Risk-weighted assets means there’s a bigger weight that’s put on something, an asset that’s risky, and a lower weight that’s put on something that’s safe, like a Treasury bill.
David: Where is it currently at? Is there an average?
Ron: There’s two separate issues. There’s what banks actually hold. Our number, the 23.5, is a requirement. It’s separate from what they actually hold. It would be the rule that would meet their minimum amount.
It ends up, David, that the US capital system is about the most convoluted, complicated thing that exists. Saying what the minimum level right now for the large banks is—it’s really hard. There’s a minimum level. There’s a bunch of buffers that could change over time. Then there’s a surcharge that gets recalculated, depending on what assets you hold. It’s really hard.
What we did was, to avoid all this complexity, we said the current minimum number is 13 percent. Why did we do that? If you look at a point in time, at a time the Federal Reserve was issuing the rule, it went into effect, about what the capital rules were going to be, they said at that point, JPMC was the largest bank at the time. They had a minimum level of 13.
That’s actually a pretty conservative number. The actual minimum capital requirement was going to be lower than that. We thought we’d basically give more credit to the current regime, so that we could compare the current regime to what we’re proposing. It would make the current regime seem more favorable. That’s why, similar to what you were talking about with Neel, we’re roughly doubling it.
David: OK, roughly doubling it. You guys, in the paper, show that this would dramatically reduce the probability of a systemic crisis, correct?
Ron: Yes. It would go down probably by 70, or closer to 40, this one step.
So where does 23.5 come from? We actually go ahead and we try to estimate the cost and benefits of additional capital. I could talk about roughly how we do that.
When you do that, you’re maximizing the benefits at 22 percent. Why not 22? We picked 23.5 because the Federal Reserve had a proposal—how much loss-absorbing capacity, is what they called it, for the largest banks. That’s equity plus a special kind of debt. That would have been at 23.5 for JPMC. Since we had 22, and they said 23.5 was the right amount, we just said 23.5.
David: Just to be clear, under the Minneapolis Plan, this capital requirement of 23.5 percent applies to banks only with assets over $250 billion, correct?
Certifying “Too Big to Fail”
David: Then the other steps—Neel mentioned these earlier, but just so our listeners are aware and have them in their mind—you got to raise capital, 23.5 percent for banks over $250 billion.
Second, the Treasury secretary would have to certify . . . there’s a five-year process, or a five-year deadline, where they have to certify whether this bank is systematically important or not, too big to fail or not. If they are not, if they’re OK, they don’t pose a systematic risk, they stick at the 23.5.
But if they are someone who is systematically important, then you guys have this kind of scale where the capital requirement actually goes up until it hits 38 percent, is that right?
Ron: That’s exactly right. And 38 percent is the point at which, if you went higher, you would no longer have net benefits. That’s where that’s coming from.
David: For banks that pose a particularly strong risk to the entire economy, they would have to fund with even more capital.
David: The third step is, you would also move into the shadow banking area. As we saw during the crisis, there was a run on the shadow banks. You guys want to make sure that if you put these capital requirements on regular banks, that the highly leveraged financial intermediation doesn’t shift over into shadow banking.
So over there, the plan, as I understand it, is you put a 1.2 percent tax on shadow banks if they are not systematically important. If they are, then it’s 2.2 percent on leveraged.
Ron: That’s exactly right. In fact, you’ve shown that you’ve read it, and that we were at least somewhat clear, because you’re describing it correctly.
David: Good, all right. What this is, again, this is for banks over $250 billion in assets. Then just one detail left out for your shadow banks, they had $50 billion in assets. Your fourth part, then, is for community banks, which is to reduce the unnecessary regulations.
I’m not going to worry too much about that component in our conversation because I want to focus more on the main goal, which is to eliminate “too big to fail.”
Ron: Can I say one thing on the community bank part?
Ron: I do think it’s relevant in the following sense. For years and years, you’ve had now policymakers across political ideology saying that they think the burden on community banks is out of whack.
But there’s been really very, very little actual work done. Why is that? Our sense is, because people are worried that if you start making changes to these small banks, you’re going to get changes also made to the large institutions that favor them.
Since they are a holding, as Neel said, things bankers built to be too big to fail, the last thing they want to do is do anything that could relax the large banks. Our take is, the reason why you have to have progress for the community banks is because people are still worried about the large banks.
The idea would be, you move forward with our plan. That would address the large bank problem. Then it would free you up to get rid of rules on the small banks that really are not value added.
David: One of the comments I saw in your report, which was nice, you replied to all the comments from the first draft of your report. One of them spoke to this question of “Why don’t you apply these increased capital requirements based on the type of economic activity rather than the size of the bank?”
I’m wondering, is this community bank distinction—does that address that question?
Ron: A little bit. I think it gets to the fact that when you asked me what the current minimum capital requirement is for large banks, it was difficult for me to say, “It’s six.” I think as a general approach for the whole entire endeavor, we just tried to stick with things that are simple to implement.
That’s one answer. The second answer is, we actually are incorporating what banks are doing in that second stage that you noted. The Treasury Department is going to have to figure out, are banks still posing a systemic risk?
There’s a framework that’s already out there we suggest they follow, looks really specifically at what are the activities of the banks involved? I think the claim that we’re not really looking at what banks are doing, it’s true for the 23.5, the straight-up asset test.
This other part of it, which is determine whether or not they’re systemically important, that’s going to be looking precisely at what we’re doing.
David: The Treasury secretary is the individual that will certify whether a bank is too big to fail and gets the additional capital requirements, and you give him a five-year deadline. One of the questions that hit me as I was reading that is, how do you make that credible?
Are there any concerns you might have that they might keep kicking the can down the road and pass that five-year deadline?
Ron: Of course, it’s always true. I would say, in the history of these capital rules, at least the ones I’ve seen, they almost are always transitioned in. I think, to date, they’ve largely been executed.
But clearly, as you get an administration, for example, in one regime, and then four years later, you get another one, they can have different views on it. I think that’s one reason why we want this to not be done through regulation, but we want it to be done through law. Then I think there are means to try to force people to obey the law.
David: Your report also mentioned that there are some facets of Dodd-Frank you would keep. You mentioned the resolutions in the paper. Living wills, I think, the orderly liquidation authority, are those parts of Dodd-Frank you would keep?
Ron: Basically, we’re keeping everything except for the capital rules and the rules associated with this loss absorbing. Maybe can I spend 30 seconds on that, what the issue is?
David: Sure, please do.
Ron: Under the Federal Reserve’s current proposal—and this is really the linchpin of how we’re going to solve “too big to fail,” allegedly, under the current regime—banks are going to fund themselves with equity, but they’re also going to fund themselves with some debt, and the debt is going to be explicitly used for the purposes of recapitalizing the institution.
A bank fails. Instead of having the government put more money into the bank, they’re going to convert these debt holders into equity holders of a future entity. And that’s how they’re going to avoid putting more money in. It’s these debt holders.
Our programmatic view is, that’s not going to work. We’ve tried something that was almost exactly like this. It didn’t work during the financial crisis. They’ve tried things like this in Europe right now. It hasn’t worked.
We think it’s not going to work going forward. So we don’t follow that part of the current regime. All of the other aspects of the current regime, we’re basically in line with the largest things.
David: I’m curious about the orderly liquidation authority in particular. I’ve had some guests on the show who worry about that part of Dodd-Frank. They take essentially a moral hazard argument, that these big banks know that, at the end of the day, if push comes to shove, they need to be bailed out, this orderly liquidation authority will come in and take over for them.
I guess the counterargument would be, if it’s going to happen, why not also try to make it systematic? What are your thoughts on that? Is this moral hazard concern warranted or not?
Ron: I think it actually circles back to the very first part of our discussion. That’s why I tried to talk a little bit about that. In the book that Gary and I wrote, and in the work we’re doing now, it’s not the existence of a fund that lets you do a resolution that creates the problem.
The problem is that when these institutions get into trouble, they, through a lot of different means, can have spillover effects on the other institutions and the real economy. That’s what’s driving policymakers to bail people out.
Creating the orderly liquidation fund—that’s just recognizing what the truth of the matter is. Maybe you could make the argument that you guys are putting in so much capital, you’re never going to need to use it.
Our take is, people put in a dyke to block a flood. You block a 100-year flood, and suddenly in a new world you don’t have the 100-year flood, but the 50-year flood. You need to have something you’re going to do.
I personally have never believed that the reason why we have a problem here is because we have these tools that are being used to address it, if it’s a problem. I think the reason they have the belief they’re going to get bailed out is because they know the complexity of the connections of these firms. If they get in trouble, you have every reason to bail them out.
So what we’re trying to do is to put equity in there to guard against that. I think that’s the best thing we can do.
David: I think there’s much agreement on that point.
I want to turn to some ideas that have been brought up by past guests. I mentioned the orderly liquidation authority’s a past concern, but there’s been other suggestions as well, different ways of addressing “too big to fail,” making our banking system safer.
I want to just throw some of them out there, and then get your response to them. Let me start with CoCos, or debt that can be turned into equity during a crisis. What are thoughts on those?
Ron: We tried to cover that a little bit. CoCos are very much like this clinical bail-in debt that I mentioned that they’re going to issue. There are some important conceptual differences, but fundamentally the idea is, a firm’s going to get into trouble. There’s going to be existing instruments that can become capital.
I think you just need to look at what happened with Fannie Mae and Freddie Mac. This was in a prior regime. People used to talk about what’s called subordinated debt, but it’s the same idea, that they would be forced to issue debt that would be very junior, so it would get converted, and there would be no problem.
Now, flash forward. You’re in a crisis, and what people are worried about is, am I going to lose my money? You’re in the middle of a crisis, and you’re telling me that the solution to making people feel comfortable, not freaking everybody out, is that you’re going to impose more losses on more people. It just seems implausible.
The only active creditor in the US where we have a record that we do impose losses on them is equity holders. We do treat equity holders differently from fixed income holders, depositors, or bond holders. I think CoCos and bail-in debt, it’s very elegant. If it worked, I think that would be great. But we have a record of it here.
I should just add, in Italy and other places, they’re using the same idea. Last year, they were confronted with this issue: what are they going to do about the bail-in debt of the Italian banks that are in trouble? They said, “We want a special exception. We’re going to need to protect those folks.”
I think that’s the history. We talked about, is the five-year delay credible? The thing that’s not credible is that in a crisis, a government is going to want to impose more losses on debt holders. [Hasn’t happened. inaudible].
David: Even if you’re very clear upfront, say these things will turn to equity in the midst of a crisis, people still think, “No, you won’t.”
Ron: The nature of the whole “too big to fail” problem is that it’s an implicit guarantee. This goes back to 30, 40 years. If you’re uninsured, they’re telling them. Uninsured depositors, what happens? They get protected.
People will say, “Well, pass a constitutional amendment that says you can’t bail people out. Pass a law that says we can’t bail people out.” People aren’t bailing people out because they want to help people—they want to help their friends, or they want to get around the law.
They’re doing it because they think, “If I look at the cost benefits, I don’t want to be the senator, congressman, president who became the next Herbert Hoover. I don’t want to be the person that goes down in history, whether it’s right or wrong, that I created a depression.”
100 Percent Equity Financing: Good or Bad?
David: Let’s move to another proposal, then. John Cochrane’s been on the show, and he’s written about this a lot. He wants to go to 100 percent equity financing. He wants to take your proposal and go all the way up.
He would have, for example, a person take out their debit card, and that debit card is backed by assets that are constantly changing in value. He argues, “Look, we’ve got the technology for it now. It’s not a big deal.”
I also had David Andolfatto from the St. Louis Fed on the show. He had a great reply, an amusing one I thought was funny. He said, “Look, that turns your debit card into a lottery machine in Vegas. You don’t know for sure from one day to the next.”
I think John Cochrane might say it might be a little more stable than a slot machine in Vegas. But what are your thoughts on 100 percent equity funding?
Ron: I think David’s getting at the point. I guess I have a two-part answer. In the current world, current technology, going to 100 percent equity funding for banks—it’s interesting to see that banks aren’t doing that themselves.
What do I mean by that? If you go back and you look over time and across countries, you will see that banks fund themselves with something that looks like a deposit. This goes way back to the historical record of the Phoenician period. There’s periods in Venice where that’s how banks fund themselves.
There’s something that markets want that’s delivered by having an institution that funds itself by something that looks like a deposit and issues a deposit that looks like a loan. Given that that’s how markets seem to operate, saying that we’re going to be equity financed 100 percent implies to me that there’s some big market demand that we’re going to meet.
What John is positing is that, well, I’m not saying it’s currently, but in some future world, this demand that markets have for something that looks like a deposit could actually be private equity. At that point, I’d be open to it. What’s interesting is that some people do that. It’d be interesting if markets would deliver that themselves.
But right now, I think I’m sort of where David’s at. I don’t think technology’s supported it. I think it runs counter to some big market demands.
David: I think that makes a lot of sense. People want, for better, for worse, they want fixed, nominal price securities, deposits. Your point is, until that demand changes, don’t expect 100 percent equity financing to take over the world.
Ron: I take a lot from the fact that it’s across country, across time. This isn’t a uniquely American thing.
David: It’s human nature. We want it, so we’ll get it. Let me throw another proposal out. Norbert Michel was on the show, and he edited a volume where some of the authors wanted to go back to double, triple liability for bank shareholders, so you would get rid of limited liability.
Historically, apparently this was the case up until about the Great Depression. You had skin in the game. The argument is that if the shareholders had skin in the game, it would better incentivize them to fund with enough capital. What are your thoughts on that?
Ron: There was some work that was done here at the Minneapolis Fed on that, that double liability thing. If I remember correctly, it actually did not work out that well at the time that it was instituted.
I think there are lots of financial crises and banking panics that were associated with double liability. I’m not quite sure of the historical record. The demand to bring something back that didn’t work in its prior incarnation, that doesn’t seem that strong.
David: I’ve seen a few papers that argue it worked OK, but the FDIC basically wiped it out. Once the FDIC came along . . .
Ron: I think you’ve got a couple colleagues—I think Tyler Cowen wrote something about Scotland, that it had been used there, too.
David: Yeah, and I think also Josh Hendrickson has a paper.
Ron: I think there’s counter-papers, which is what I’m saying. I think it’s a mixed discussion. I’m not just trying to throw up a smokescreen. I know you [inaudible]. I do think the historical record isn’t entirely . . .
I think the second thing would be, there’s other ways that you can get people with skin in the game. Our own proposal is a version of that. You’re going to have equity holders. That’s the whole point, that they’re going to have some skin in the game.
Deposit Insurance and Shadow Banking
David: Absolutely. I think both of these approaches would ultimately lead to more skin in the game. Let me move on to another guest I had on the show, Morgan Ricks. I don’t know if you’ve seen his book. But his proposal as it relates to our conversation today is that any institution that issues money-like liabilities, whether it’s a traditional bank or a shadow bank, would only do so if they fall under a certain form of institution.
They’d have to, I guess, incorporate into a certain type of moneylending institution, and they would all be backed up by FDIC. Basically, extend FDIC to any institution that issues any kind of money-like liabilities. What are your thoughts on that?
Ron: One thing I like about this proposal is its transparency.
There’s two ways of getting at what we’re trying to do. One way would be what we’re saying, which is, “Hey, you ought to impose a cost now that’s going to absorb the losses, and that’s going to prevent people from having concern when their bank gets in trouble.”
Another one is the complete opposite, which is to say, “We’re going to put the government much more out there. They’re going to guarantee more things. Because they’re guaranteeing more things, then there’s less of a concern when an institution gets in trouble because there’s less ways that the problem can spread from one institution to another.” There’s not going to be a bust, because everybody’s guaranteed.
I’m not saying that’s exactly what Morgan’s proposing, but it’s along those lines. The question there is, it’s the tricky one. If you’ve got a much better government guarantee, then the issue of moral hazard seems like it’s much more present. I think that’s a turnoff, but I do like the idea that it’s transparent, and I think it would largely work. The question is, what kind of cost would it come with?
Opening up Central Bank Balance Sheets?
David: Yes. Last alternative proposal by a guest, J.P. Koning. He’s a blogger I had on the show. He has mentioned that in the past, central banks opened up their balance sheets to everyone.
He gave the example in particular of the Bank of England. It used to be the case people could actually have a checking account directly at the Bank of England. That got phased out. Then eventually, just the employees had checking accounts at the Bank of England. Then that finally got phased out recently.
But the idea is, if you had a checking account at the central bank, it would be the safest account in the world. J.P. Koning recognizes that, what would this do to financial intermediation elsewhere in the economy? That would be the big pushback.
What would happen to banks? His argument is, “Well, those banks would still exist. They would provide services that the central bank doesn’t provide.” What are your thoughts on opening up the Fed’s balance sheet just to anyone?
Ron: I haven’t actually heard that before. [laughs]
David: It’s radical. It’s very radical.
Ron: I guess it’s another version of the 100 percent guarantee. People want something that looks like a deposit. If they’re worried about the condition of their bank, they’re going to run, and it’s those runs that lead to this instability.
Again, our idea is, just make it very hard for the bank to get in trouble because the equity would avoid it. There’s this other school of thought—Morgan’s proposal is a version of this proposal—which says, “No, just have the deposits provided in a really, really safe way.”
I sort of talked about this, but the insurance concern, then you have a lot of moral hazard, and here they articulate it. What is the central bank, and if the central bank is just going to hold assets, the central bank becomes huge money market account.
We’re just getting back to the point we talked about before, that there is something of the combination of deposits with risky assets that’s a useful combination. If you think that’s useful, you think banks to provide market service, it’s not really obvious this is a great idea.
David: I’m not comfortable with the idea. It’s an interesting one. I see its appeal because it’d be super safe, but I do worry about the larger footprint the Fed would have in the financial system if they did something like that.
Ron: I guess I would phrase it the other way around. We’re saying the same thing. It’s less that I worry about the Fed’s footprint, per se. It’s more that banks provide a useful service. It’s linked to deposit taking and bank loans.
Before we try to destroy that through policy, let’s think really carefully about what the implications are going to be. Because banks make lots of loans to people who can’t get funding otherwise, and that’s a really key part of the economy.
If that’s the whole reason for a financial crisis, is that banks get into trouble and they stop making the loans they were making before . . . If we’re going to have a policy that basically emasculates banks completely, we have a real confidence that that’s not going to destroy a lot of lending that’s very productive, which I don’t . . .
David: I completely agree. That was J.P.’s reply, is banks would still do that. It’s not clear to me that would work out. Like you said, it might emasculate banks.
Also, the other concern I would have with that approach is that you would end up like some of these banks in China. If the Fed did get in the business of making the loans to regular people, it’s not clear to me they would do a very good job. There’d be corruption. There’d be all kinds of issues that would emerge.
Ron: Yeah, I’ve never heard anyone in my entire career at the Federal Reserve ever say that they’re interested in that business.
Ron: There’s no demand from the Fed to do that.
David: The Fed would be even less popular than it is at times. [laughs]
Let’s go back to your plan, the Minneapolis Plan. You spent several years on this. I imagine you’re one of the key architects of it since you’ve been working on these issues for a long time. Where do you see it going?
I know I talked to Neel about this earlier, but in addition to conversation, are there more conferences lined up? Are you commissioning more research on this? What do you see happening next?
Ron: I don’t think we’re going to do anything in the short term. I don’t think this year, I can’t imagine us having a conference on it. I think we’re going to try to talk to people about what we’re doing, and we’re going to try to see where the environment goes.
Again, speaking for myself, clearly, it’s one thing to stay with the current regime, which we’re not in favor of and which we think has got a lot of problems. It would be even worse in my mind, to try to roll back, maybe have banks holding even less capital—that would be disastrous and really disappointing. I was hoping it would take at least 20 years to forget the worst financial crisis since the Depression. To forget within a decade is discouraging.
But anyway, I think we would look to where people are moving and try to talk to people who are interested in it, but I don’t think we’re going to be trying to convene people or do something like that unless there’s interest. I think we’ve been clear where we’re at. At some point, you have to let the market respond to whether there’s interest in your proposal.
David: OK. That is very interesting. It’s been a fun conversation with Neel Kashkari and Ron Feldman. Ron, thank you for coming on the show.
Ron: Yeah, I appreciate that. Thanks for asking. I’ve also got a chance to geek out here for a bit, so that was good. Thanks.