Editorial Board

Kashkari's Big Plan for the Banks

The best way to protect the financial system is also the simplest.

Off to a strong start.

Photographer: Chris Goodney/Bloomberg

The new president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, has gotten off to a bold start. In a speech this week, he warned that almost eight years after the financial crisis, the largest U.S. banks still pose a grave risk to taxpayers and the broader economy. Dealing with this problem, he said, will require a “transformational restructuring.”

He’s right that the financial system needs further reform, and it’s good that he’s open to radical proposals. But one thing should be clear at the outset: The best way to make banks safer is also the simplest. Require them to finance themselves with more capital and less debt.

Kashkari played a central role in the U.S. Treasury’s efforts to shore up the financial system in 2008. He knows the terrible choice that policy makers faced: rescue big banks at taxpayer expense, or risk a worse disaster. He’s convinced that -- despite the complex panoply of rules and mechanisms put in place since then -- the government will be in much the same position when the next crisis happens.

“We hated that we had to bail out the banks,” he said Wednesday on Bloomberg Television. “None of us wants to be in that situation again.”

He says three far-reaching options should be looked at seriously. The government could divide large banks into smaller, less systemically important entities. It could tax leverage throughout the financial system. Or it could substantially raise capital requirements. Kashkari says the Minneapolis Fed will undertake this study and suggest an "actionable plan."

Breaking up the banks has great populist appeal because it sounds like punishment, but the idea is seriously flawed. The government isn’t competent to judge how banks could best be broken up, and a larger number of smaller, inadequately capitalized banks might be just as dangerous as a few big ones. Excessive leverage does make the system more fragile, but taxing it could actually encourage institutions to take greater risks to compensate for the cost. Having done so, they might count even more on the government to rescue them when things go wrong (after all, they paid their taxes).

QuickTake Capital Requirements

The capital approach is much more straightforward. Equity is money from shareholders that banks can invest. Unlike debt, it makes banks more resilient by absorbing losses in bad times. Requiring more of it curbs banks’ reliance on implicit government subsidies and makes shareholders more responsible for risk -- creating a natural incentive to devise simpler and more transparent operations. Research and experience suggest that the benefits to the economy would far outweigh the costs.

Kashkari will do taxpayers a great service if he can bring renewed attention to the unfinished work of building a safer financial system -- especially if he recalls another lesson from the financial crisis. Regulators are defeated time and again by complexity. Keep it simple, and the right kind of transformation will follow.

Neel Kashkari: Hated That We Had to Bail Out Banks