Thoughts on The Minneapolis Plan to end TBTF

By | December 6, 2016

The Minneapolis Plan’s focus on the too-big-to-fail (TBTF) problem appears to conflate, or at least ignore, cause and effect. The TBTF problem is widely viewed as comprising two evils: that systemically important banks might engage in excessive risk-taking because they would profit by a success and expect to be bailed out by the government to avoid a failure; and that government will have little choice but to bail out failing systemically important banks, lest their losses be imposed on other banks. The Minneapolis Plan focuses only on the latter evil—the effect, not the cause.

Indeed, the Plan specifically defines the “TBTF problem” as having that narrow focus: merely being the possibility that “the largest and most systemically important banks fail and impose their losses onto other banks.” Plan p. 2. This ignores how systemically important banks contributed to the 2007-08 financial crisis and could trigger future crises. A comprehensive plan to solve the TBTF problem should also examine the fundamental question of why systemically important banks might fail.

The Financial Crisis Inquiry Commission has begun that examination, identifying excessive risk-taking by systemically important banks as a primary cause of the financial crisis,[1] and others concur with that view.[2]  If excessive risk-taking causes systemically important banks to fail (requiring them to be bailed out before they “impose their losses onto other banks”), any plan to address the TBTF problem should also address that risk-taking. Some have already examined excessive risk-taking and its causes. I have argued that excessive risk-taking may result less from moral hazard and more from a legally embedded conflict between corporate governance and the public interest that allows managers of systemically important firms to ignore systemic externalities.[3] The Minneapolis Plan does not, however, take the cause of failure into account.

Ignoring causation can undermine the Plan’s recommendations. Because the Plan implicitly assumes that systemically important banks fail, its recommendations center on requiring high levels of common-equity capital to prevent such failures. Some economists (such as Professors Admati and Hellwig, whom I greatly respect) argue that high capital requirements have little associated public costs, but others argue to the contrary. Without attempting to resolve that debate, I merely observe that if high capital requirements are costly, it would be worth examining whether other more targeted remedies (such as trying to mitigate the corporate governance conflict) could be more efficient.

Here’s a simple way to think about this last point. The Dodd-Frank Act’s limiting the Fed’s bailout powers under § 13(3) of the Federal Reserve Act has been analogized to shutting down fire departments in order to make homeowners more careful about starting fires. If requiring high levels of common-equity capital to prevent a bank failure is in fact very costly, then the Plan’s requirement that systemically important banks hold that capital is like making houses completely fireproof instead of improving the effectiveness of fire departments. That may well prevent the houses from burning down, but it is likely to be extremely expensive.

Ignoring causation raises other problems in the Plan, though less serious. For example, the Plan states that as a result of the TBTF problem—which, as indicated, it defines as the possibility that systemically important banks fail and impose their losses onto other banks— “trillions of dollars in American wealth was destroyed.” Plan p. 2. But that wealth destruction resulted from the financial crisis itself. The net cost of bailing out systemically important banks may actually be relatively minimal because the government has been recouping much of that investment.

 

[1] Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States xviii–xix (2011)

[2] See, e.g., [Secretary of the Treasury] Jacob J. Lew, Opinion, Let’s Leave Wall Street’s Risky Practices in the Past, Wash. Post (Jan. 9, 2015) (repeatedly attributing the financial crisis to “excessive risks taken by financial” firms); The Origins of the Financial Crisis: Crash Course, Economist (Sept. 7, 2013), http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article (identifying excessive risk-taking as one of three causes of the financial crisis, the other causes being irresponsible lending and regulators being “asleep at the wheel”).

[3] See, e.g., “Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility,” available at available at http://ssrn.com/abstract=2847026

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