Kashkari Highlights Too Big To Fail Reform

By Norbert Michel, Heritage Foundation Financial Regulations Expert

It’s always good when a Federal Reserve Bank president talks about ending bailouts for large financial companies.  At the very least, the publicity highlights the fact that the Dodd-Frank Act did not end the “too-big-to-fail” problem.

So, many policymakers were excited last April when new Minneapolis Federal Reserve President Neel Kashkari announced his bank would develop a plan to end too-big-to-fail. Others, more skeptical, felt that Mr. Kashkari, who had been in charge of the $700 billion Troubled Asset Relief Program (TARP), might not be the best person for the job.

In November, Kashkari’s bank released its report. It included the following four-step solution to end too-big-to-fail:

  • Increase banks’ capital requirements;
  • Force banks to raise even more capital unless the U.S. Treasury can certify that they do not pose a systemic threat to the U.S. financial system;
  • Tax large non-bank financial firms;
  • Provide regulatory relief to community banks.

Count me among those who are less than ecstatic.

This “solution” is based on the notion that elected officials just can’t quit bailing out large financial firms. Accepting that as a given, it then concludes that they  should regulate the companies more heavily, tax them more heavily, make them meet higher equity thresholds, and then, for good measure, give regulatory relief to small banks.

These steps are eerily similar to the regulatory approach that gave us (at least) the last two crises.  The one “plus” to this plan is that it tacitly concedes that the problem is not fixed, so that’s kind of a victory.

Now Kashkari is at it again.

His new idea was unveiled last week in a Wall Street Journal column headlined “Make Big Banks Put 20% Down—Just Like Home Buyers Do.”  Kashkari presents his latest “simple and fair solution to the too-big-to-fail problem” this way:

“Banks ask us to put 20% down when buying our homes to protect them in case we run into trouble. Similarly, taxpayers should make large banks put 20% down in the form of equity to prevent bailouts in case the financial system runs into trouble.”

There’s definitely the kernel of a great idea in this piece. Higher equity can help banks absorb more losses.  But that fact, alone, is not nearly enough to end bailouts.

There’s a much bigger problem with Kashkari’s thesis: Banks ask some people to put 20 percent down on their home loans, but it’s far from the norm thanks largely to government policies that shift financial risk to taxpayers.

Almost all Federal Housing Administration (FHA), Veterans Affairs (VA), and Rural Housing Service (RHS) loans are made with less than 20 percent down. In fact, close to 90 percent of these loans are made with less than 10 percent down.

There’s more.  Nearly half of the loans purchased by Fannie and Freddie have been made with less than 20 percent down, and almost one-third have less than 10 percent down.

Combined, nearly 70 percent of all government-backed mortgages – Fannie, Freddie, FHA, VA and RHS – are for loans with less than 20 percent down.

Because federal backing has been so prevalent since the 2008 meltdown, nearly all new mortgages since the crisis have had less than a 20 percent down payment. (All of these figures are compiled from government data and available here).

Reversing this trend toward smaller down payment home loans would surely lower risk in the U.S. financial system, but it would be completely inconsistent with federal policy for the last century.

And it’s just as inconsistent for the federal government to force banks to hold such high equity and simultaneously encourage individuals to take on more low equity loans.  Such a policy suggests that banks should be penalized for taking on higher risk after being forced to do so.

But now that Kashkari has highlighted this issue, it’s the perfect opportunity to start backing away from those bad policies that encourage individuals to borrow with virtually no skin in the game.

A valid concern is that moving to higher down payments right now would be a shock to the market, but that’s really just an argument for moving to the new framework gradually.  If, for example, higher down payment requirements are phased in over the next decade, it would dramatically reduce the amount of risky loans made and give people time to adjust.

For exactly the same reasons, ramping up banks’ required capital on the same schedule would be a major policy improvement—provided, of course, that the phase-in is paired with regulatory relief.

By Kashkari’s own logic, higher equity lowers risk.  If there’s less risk, there’s less justification for regulation. Throw in the fact that massive amounts of regulation have repeatedly failed to prevent financial crises, and it’s a win for everyone.

Maybe the Minnesota Fed can sponsor another symposium.

*Originally published in Forbes, click here.

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