In 2008 the world hovered on the brink of what looked to be a global economic meltdown. Without going too far into it, the cross section of deregulation and an increasingly complex financial sector led the country to the brink. Complex financial instruments started to deteriorate at an alarming rate, and their impending default threatened to create a collapse of the banking sector and an ensuing crash of the other sectors of the world economy to follow. Through a series of controversial policies, namely the bailout and TARP, the economy pulled out of the tailspin despite being direly wounded.
The Dodd-Frank reforms were passed in the wake of the crash in order to avoid repeating the calamity in the future. Opinions are divided on the effectiveness of the reforms. Critics say that the bill places too high a cost of compliance on small banks. Still others say that the reforms don’t provide enough protection. One thing is certain, the banks that were too big to fail are bigger than they ever were as a result of the consolidation of the banking sector that was necessary to help the industry through the tumult. Furthermore, the exotic derivatives that were at the center of the meltdown, called collateralized debt obligations, or CDO’s, are being sold again under the name bespoke tranche opportunities. It appears that many of the same dangerous behaviors that started the troubles of the last decade are ongoing today. Recently, the Minneapolis fed put forward a plan that may address many of the concerns.
Neel Kashkari is a free market believer and a Republican. So much so that he considers Jeb Bush a political mentor. He believes in cutting Social Security and Medicare, and he even went on record praising Scott Walker’s efforts to bust up unions in Wisconsin. He is also critical of the Dodd-Frank reforms, but not in the way you might think. He thinks they are not strict enough, and he’s got good reason to.
Neel Kashkari was on the inside of the effort to stop the catastrophic failure of our economy. During the main thrust of the effort, he was working with Henry Paulson at Treasury as the Assistant Secretary of the Treasury for Financial Stability, meaning he was one of the ones looking into the abyss and trying to think of ways to deal with problems orders of magnitude larger than anything the country faced in decades. Neel Kashkari’s is now the President of the Federal Reserve Bank of Minneapolis. Last November, the Minneapolis Fed, headed by Kashkari, announced a plan to end the problem of too big to fail.
The current remedy lies in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The act imposes stress tests on banks to ensure that they could survive and respond to bank runs under a variety of circumstances, but Kashkari and his team hold that they do not go far enough. They say the circuit breakers that are built in are complex and rely on too many moving parts. They also point to the act only requiring 6% equity capitalization as insufficient.
The Minneapolis fed plan has requirements that would call for common equity capital equal to 23.5% of risk weighted assets. This level would apply only to what they call covered banks, or banks with assets equal to or greater than $250B. The second step would require the Treasury to determine which, if any covered banks remained systemically important, or more commonly known too big to fail. Banks that are deemed systemically important would be subject to a higher equity requirement of 38%. This higher capital requirement would be realized in a plan stretched out over five years. There are also leverage taxes added to the plan that would prevent the same risk from being moved to shadow banks.
After implementing the first step, they claim, the risk of a bailout from the public will go down from 67% over a 100 year period (the risk level they assess to be associated with current regulations), to a 39% likelihood. The second step is said to lower the risk of a bailout to 9% or lower over a 100 year period.
Another benefit they tout is that the regulatory environment will become simpler and less onerous for smaller regional banks, which is one of the main complaints of detractors of the current Dodd-Frank regulations.
The plan would certainly wind up forcing some of the largest banking institutions to reorganize and break themselves into smaller units so as to avoid being deemed systemically important. This, they say, is not their concern.
Whether or not this plan is the magic bullet, the fact remains that Wall Street is a sword of Damocles hanging over our collective heads. In fact, the securities that were the major amplifier of the mortgage crisis (CDO’s) are back under a different name.
Defusing the too big to fail ticking time bomb is of vital importance to the economic future of our nation.