What Price Safety? Minneapolis Fed Plan to Cut Bank Risk Would Also Cut Growth

The following article, originally published at 8:28 a.m. on Wednesday, Nov. 16, 2016, has been updated with comments from the banking industry.

The largest U.S. banks would have to maintain a capital reserve as high as 38% of lending assets under a plan proposed by Minneapolis Fed chief Neel Kashkari to curb the risk of government bailouts like those in 2008.

Kashkari, who oversaw a Treasury Department program designed to prevent further collapses after the bankruptcy of investment bank Lehman Brothers in 2008, said the Minneapolis plan would curb the odds of future bailouts to less than 10% over a century, compared with 84% before the crisis and 67% today. Capital reserves, buffers intended to cushion against failure, were previously increased under the Dodd-Frank finance reform law in 2010. 

"It is simply impossible to make that risk zero, and safety isn't free," Kashkari said in a speech Wednesday before the Economic Club of New York. "Regulations can make the financial system safer, but they come with the cost of potentially slower economic growth. Ultimately, the public has to decide how much safety they want."

The plan, which would be implemented in phases, is the result of a year-long initiative to study the risk of so-called too-big-to-fail institutions that Kashkari announced in February, shortly after taking the helm of the Minneapolis bank. It would initially require lenders with assets of more than $250 billion to raise common equity equal to 23.5% of assets. Those that remained systemically important afterward -- in other words, still posing a risk to the economy if they failed -- would have to raise as much as 38% over time.

The proposal also levies a tax of 2.2% on borrowings higher than $50 billion by shadow banks the Treasury secretary deems systemically important. Those with lower risk would pay only 1.2% on such debt.

Kashkari conceded that the regulations would further crimp the profitability of large financial institutions. 

Earnings at the biggest U.S. banks, from JPMorgan Chase (JPM) to Goldman Sachs (GS) and Bank of America (BAC) , have already been eroded by heightened regulation and capital requirements since the crisis, and some analysts and lawmakers have argued that those restrictions were partly responsible for slower U.S. economic growth.

Indeed, Kashkari's proposal, dubbed the Minneapolis plan, estimates current regulations cost about 11% of U.S. gross domestic product and full implementation of his proposed changes would pare about 41%. That compares, however, with the cost of a banking crisis, which the Bank for International Settlements pegs at about 158% of gross domestic product in a worst-case scenario -- roughly $28 trillion in the U.S. today.

"If the Minneapolis Plan prevents one financial crisis, it will have paid for itself multiple times over," Kashkari said Wednesday. "These are the trade-offs the public needs to understand in order to assess whether we have done enough to end 'Too Big to Fail' or if we should go further. To me, these data make it very clear that we should go much further."

The typical cost of a banking crisis may well be much less than 158%, however. The Clearing House, the oldest U.S. banking association, says an estimated cost of 63% -- the middle of three figures outlined in the BIS report -- would shave $11 trillion from the U.S. economy, while providing a $5.9 trillion benefit in reduced crisis risk

The net, in that scenario, would be a $5.2 trillion cut to U.S. gross domestic product, which is currently about $18 trillion. Spread over the U.S. population, that's a cost of $15,988 per person.

"They're proposing a plan that has negative benefits," Bill Nelson, chief economist with The Clearing House, said in a telephone interview. "It would be very costly to the U.S. economy, in terms of GDP growth and in terms of jobs, to have such a massive increase in capital."

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