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Friday, May 13, 2016

Ending "Too Big to Fail": What's the Right Approach?

Ben Bernanke:

Ending "too big to fail": What's the right approach?: In a recent speech at the Hutchins Center at the Brookings Institution, Neel Kashkari, the new president of the Federal Reserve Bank of Minneapolis, argued that we need new strategies to tackle the problem of “too big to fail” (TBTF) financial institutions. On Monday, I’ll be on a panel at the Minneapolis Fed on the issue. This post previews my comments. In short, it seems to me that a lot of progress has been made (and more is in train)... To say that “nothing has been done” is simply not correct. ...
At the 50,000-foot level, a key question is the extent to which structural change in the financial industry is needed to end TBTF, and, to the extent it is, what that change should look like. The argument of this post is that, while substantial and even fundamental changes may ultimately be necessary, we don’t yet know exactly what they will be. Instead, the legacy of the Dodd-Frank Act, the Basel agreements, and other reforms is a sensible process which, with sustained effort, will help us solve the problem. A key element of the strategy is that it gives banks strong incentives to shrink or otherwise restructure themselves to reduce the risk they pose to the financial system.
Why not just break up big banks? ...
My takeaway is not that the problem is solved—that will take more time—but rather that the current approach amounts to a process that will help us find the solution. In particular, the government’s strategy for ending TBTF addresses the deficiencies, noted above, of imposing arbitrary limits on bank size. Most obviously, the strategy does not make the mistake of treating size as the only determinant of systemic risk (e.g., capital surcharges depend on a variety of criteria). ...
If, as seems probable, bank managers and shareholders better understand the institution’s motivations for size and complexity than regulators do, it makes sense to use that knowledge. To do that, the right incentives need to be provided: The privately perceived benefits of TBTF status need to be reduced and the costs increased, so that bank managers and shareholders are considering something closer to the social costs and benefits of size and complexity when they think about how to organize their business. ...
To a first approximation, that’s what the government’s approach aims to do. For example, the capital surcharge and similar regulations directed at systemically important institutions act like taxes on size and complexity. ... That is, the extra costs that regulators impose on systemic institutions force their decisionmakers to “internalize the externality” that their firms create for the financial system. [4] Similarly, the development of the liquidation authority (which raises the probability that creditors will take losses) and improvements in the overall resilience of the financial system (which would reduce any incentive that future regulators might have to try to engineer a bailout) should reduce the perceived benefits associated with TBTF status, as measured in terms of funding costs, for example. Putting creditors at risk also brings market discipline back into play, putting additional pressure on managers not to take excessive risks. Together with the requirements imposed by the living will process, better incentives for managers, shareholders, and creditors should lead, over time, to a banking system that is safer, but also more competitive and efficient.

    Posted by on Friday, May 13, 2016 at 08:24 AM in Economics, Financial System, Regulation | Permalink  Comments (49)


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