Section 1: Summary of the Minneapolis Plan to End Too Big To Fail

This is the November 2016 draft of The Minneapolis Plan to End Too Big to Fail. See the final Plan here.

The Minneapolis Plan reduces the risk of financial crises and bailouts to as low as 9 percent, at only a modest economic cost relative to the typical cost of a banking crisis. We calculate that the current regulations put into place after the 2008 financial crisis reduced the 100-year chance of a bailout from 84 percent to 67 percent.¹

 

In sum, the Minneapolis Plan will (a) increase the minimum capital requirements for “covered banks” to 23.5 percent of risk-weighted assets, (b) force covered banks to be no longer systemically important—as judged by the U.S. Treasury Secretary—or face a systemic risk charge (SRC), bringing their total capital up to a maximum of 38 percent over time, (c) impose a tax on the borrowings of shadow banks with assets over $50 billion of 1.2 percent for entities not considered systemically important by the Treasury Secretary and 2.2 percent for shadow banks that are systemically important, and (d) create a much simpler and less burdensome supervisory and regulatory regime for community banks. ²  Covered banks and shadow banks will have five years after enactment of the minimum capital requirement and shadow bank tax to come into compliance. The assessment of systemic risk by the Treasury Secretary will begin at this five-year mark.

We come to this recommendation after a year-long review and analysis of the TBTF problem and after consulting with a broad range of experts and the greater public.

The main points and findings of our plan and analysis are the following:

The TBTF problem continues to be one of the most serious long-term risks to the U.S. economy.

The TBTF problem arises when the largest and most systemically important banks fail and impose their losses onto other banks. The spread of these losses fuel contagion as turmoil spreads throughout financial markets and into the rest of the economy. As the U.S. economy experienced in the most recent crisis, these spillover losses have the ability to cause massive and widespread economic devastation. When faced with economic catastrophe, government leaders are often compelled to act and to stop the hemorrhaging by bailing out large banks, bank managers, and those who lent money to the banks.

In 2008, the risk of contagion presented by TBTF banks was central to the financial crisis. As a result, trillions of dollars in American wealth was destroyed. Even now, eight years later, the effects of the crisis continue to be felt throughout the economy.

Despite reforms, the TBTF problem continues to persist.

Soon after the crisis, policymakers moved swiftly to approve reforms to the financial system to help move the country in the right direction. These reforms have indeed strengthened the financial system, and we support many of these efforts. However, many experts agree that TBTF still exists today because current plans to address it have not been fully implemented. More importantly, we believe that the current plan, even when fully implemented, will not sufficiently minimize the threat of TBTF.

The current plan fundamentally rests on the belief that the government will, through a complicated scheme, force debt holders of TBTF banks to absorb losses—even when the economy and financial markets appear weak. Yet our experience in the 2008 crisis teaches us that when markets show weakness, even debt holders of TBTF financial firms who were informed that they would bear losses in such times of distress do not actually incur any hit. This recent lesson of history and human behavior in times of market stress makes clear that it is not credible to believe that any scheme, especially a complicated scheme, would work to impose losses on debt holders of TBTF banks when the next crisis occurs. We have no reason to believe that the government will follow through on its current plan in the next crisis because imposing losses on debt holders of TBTF banks in a weak environment will be viewed as too risky and complex with a high likelihood of intensifying a crisis.

A wide range of transformational reforms to end TBTF were considered.

Within our year-long ending TBTF initiative, our review included, but was not limited to, breaking up the banks, forcing banks to become much safer through higher levels of equity funding, taxing leverage, and improving the resolution regime for banks. In evaluating these various proposals, two guiding principles emerged as the basis of any policy recommendations: Reforms must be simple enough that they can be easily implemented and allowed to work amid the chaos of a crisis, and reforms must pass a benefit and cost test.

As discussed below, our proposal effectively melds ideas from virtually all of these transformative proposals. We advocate for much higher capital levels for large banks and a tax on leverage for shadow banks. We also believe our plan will lead covered banks to break themselves up to become non-systemically important while funded with much more capital. The societal benefit will be a financial system with smaller banks with a much lower chance of failure.  If these smaller banks do fail, they will not trigger contagion to other banks and the broader economy.

We do not view improvements to currently proposed resolution schemes as a viable option because they focus on imposing losses on creditors during a crisis. We also do not support breakup plans that merely separate investment banking from commercial banking. This latter recommendation simply focuses on the wrong issue and would not prevent future bailouts.

Guiding Principles of the Minneapolis Plan

After a year of study and analysis, we conclude that a higher equity requirement is the best reform policy because it is simple to implement and directly addresses the TBTF issue. When covered banks issue more equity, their individual likelihood of failure is reduced and the risk of and magnitude for contagion spreading across banks or throughout the economy are also lower. We stress that the equity must be of high quality. In our plan, we restrict our definition of equity capital to be common equity or closely related items.³ We acknowledge that a byproduct of imposing higher capital requirements onto banks may be the migration of risky activity from the banking sector to nonbank financial firms, where capital requirements are lower, if they exist at all. We address this unequal treatment across sectors by taxing the borrowings of large nonbank financial firms—also known as shadow banks. This tax would effectively make the cost of funds roughly equivalent between large banks and nonbanks.

In crafting the Minneapolis Plan, one of our concerns was the treatment of community banks. A primary purpose of the ending TBTF initiative is to reduce the risk of contagion when systemically important banks fail. Community banks, however, do not pose the same level of risk as large banks.  It is certainly a traumatic event when a community bank, or even several, fails.  We do not minimize the consequences to those who are forced to take losses in such instances.  Such localized failure, however, does not threaten the overall economy. Thus, community banks deserve a separate regulatory and supervisory solvency regime that recognizes their role in the financial system and focuses on the few, but important, factors that truly put them at risk of failure.

The Minneapolis Plan to end TBTF has four steps:

• Step 1. Dramatically increase common equity capital, substantially reducing the chance of bailouts

  We will require covered banks to issue common equity equal to 23.5 percent of risk-weighted assets, with a corresponding leverage ratio of 15 percent. This level of capital nearly maximizes the net benefits to society from higher capital levels. This first step substantially reduces the chance of public bailouts relative to current regulations from 67 percent to 39 percent. This substantial improvement in safety comes at a relatively low cost of gross domestic product (GDP). Covered banks will have five years to come into compliance with this requirement.

• Step 2. Call on the U.S. Treasury Secretary to certify that covered banks are no longer systemically important, or else subject those banks to extraordinary increases in capital requirements, leading many to fundamentally restructure themselves

  Once the new 23.5 percent capital standard has been implemented, we will call on the Treasury Secretary to certify that each covered bank is no longer systemically important. Our proposal gives the Treasury Secretary the discretion to make this determination so that it can rely on the best information and analysis available.  We suggest that the Treasury start by reviewing existing metrics of systemic risk used to determine current GSIB surcharges. The Treasury will also have the authority to look beyond covered banks in making its determination.   If the Treasury refuses to certify that a covered bank is no longer systemically important, that bank will automatically face increasing common equity capital requirements, an additional 5 percent of risk-weighted assets per year. This process will begin five years after enactment of the Minneapolis Plan. The bank’s capital requirements will continue increasing either until the Treasury certifies it as no longer systemically important or until the bank’s capital reaches 38 percent, the level of capital that reduces the 100-year chance of a crisis below 10 percent.

  Step 2 is a critical step for ending TBTF. Under the current regulatory structure, there is no explicit timeline for ending TBTF, and regulators never have to formally certify that large banks and shadow banks are no longer systemically important. Instead, banks and designated nonbank financial firms can continue to operate under their explicit or implicit status as TBTF institutions potentially indefinitely. The Minneapolis Plan reverses this approach and gives the Treasury Secretary a new mandate with a hard deadline. Five years after enactment of the Minneapolis Plan, the Treasury either will certify that large banks are no longer systemically important or those banks will face extraordinary increases in equity capital requirements.

  We believe that these automatic increases in capital requirements will lead banks to restructure themselves such that their failure will not pose the spillovers that they do today and lead to future bailouts. We chose the capital level that reduces the probability of a bailout in Organisation for Economic Co-operation and Development (OECD) countries to 10 percent or below while keeping total costs below benefits. This level of capital is appropriate for the largest banks that remain systemically important, as their failure alone could bring down the banking system.

  The only banks that could remain systemically important after the Minneapolis Plan has been fully implemented would have 38 percent common equity capital, with a risk of failure that is exceptionally low. This is a similar approach regulators have taken with nuclear power plants: While not risk free, they are so highly regulated that the risks of failure are effectively minimized. Step 2 of the Minneapolis Plan reduces the chance of future bailouts to 9 percent over 100 years.

• Step 3. Prevent future TBTF problems in the shadow financial sector through a shadow banking tax on leverage

  We discourage the movement of activity from the banking to shadow banking sector by levying a shadow bank tax. The tax equalizes the funding costs between the two sectors.  The tax will have two rates.  To equalize funding costs with a 23.5 minimum equity requirement, we would levy a tax on shadow bank borrowing of 1.2 percent. This tax rate would apply to shadow banks that do not pose systemic risk as judged by the Treasury Secretary. A tax rate equal to 2.2 percent would apply to the shadow banks that the Treasury refuses to certify as not systemically important. Thus, the shadow bank tax regime mirrors our two-tier capital regime. These taxes should reduce the incentive to move banking activity from highly capitalized large banks to less-regulated firms that are not subject to such stringent capital requirements. Nonbank financial firms that fund their activities with equity do not pay the tax. Shadow banks will have five years from enactment of the Minneapolis Plan before they begin paying the shadow bank tax. The Treasury Secretary will start making certifications as to the systemic importance of shadow banks at that point. Here, too, we grant the Treasury discretion to look across all nonbank financial firms in its certification process.

• Step 4. Reduce unnecessary regulatory burden on community banks

  Ending TBTF means creating a regulatory system that maximizes the benefits from supervision and regulation while minimizing the costs. The final step of the Minneapolis Plan would allow the government to reform its current supervision and regulation of community banks to a system that is simpler and less burdensome while maintaining its ability to identify and address bank risk-taking that threatens solvency.

The rest of this document is organized as follows:

• Section 2 discusses the proposal in more detail, focusing on key support and motivation for our recommendations.
• Section 3 describes the general empirical approach behind our capital and leverage tax recommendations.
• Section 4 describes the more technical calculations behind the capital and leverage tax recommendations.
• Section 5 provides a very brief vision for the future of the banking system once the Minneapolis Plan is implemented.
• Section 6 is a request for comments on the Minneapolis Plan.

The appendix describes some but not all of the input we received in the process of engaging with the public and experts on steps to end TBTF.

Other references are compiled at the end of the document.

A Summary for Policymakers is also available.

Endnotes

1 The Board of Governors of the Federal Reserve System is considering changes to the capital regime facing the largest and most systemically important banks. We do not consider these potential changes to be part of the current capital regime given their preliminary nature. Governor Daniel Tarullo noted that under these potential changes, “the [globally systemically important banks] will see their capital requirements rise. All other [Comprehensive Capital Analysis and Review] firms will see some reduction in their capital requirements.” See Tarullo (2016).

2 Covered banks are bank holding companies in the United States with assets equal to or greater than $250 billion. We choose the $250 billion level as our initial threshold, as this size is consistent with an important definition of systemically important banks. For example, the Federal Reserve requires banks of this size to comply with the Liquidity Coverage Ratio. Covered banks as of the most current regulatory reports (June 30, 2016) were Bank of America Corporation, Bank of New York Mellon Corporation, Citigroup, Capital One Financial Corporation, Goldman Sachs Group, HSBC North America Holdings, JPMorgan Chase & Company, Morgan Stanley, PNC Financial Services Group, State Street Corporation, TD Group U.S. Holdings, U.S. Bancorp, and Wells Fargo & Company. We do not address the treatment of financial market utilities in our plan.

3 We are counting as “common equity” the items that are allowed to count in the Common Equity Tier 1 requirement, which is defined as common shares for regulatory purposes, surplus stock, retained earnings, accumulated other comprehensive income, and common shares issued by consolidated subsidiaries. The sum of these elements is subject to a limited set of regulatory adjustments. For more specifics, see the Federal Register, vol. 78, no. 198 from Oct. 11, 2013. This rule implements the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.