Banking in the Ninth

The Minneapolis Fed’s Too Big to Fail Initiative: The Link to Community Banks

Ninth District Highlights - September 2016

Ron J. Feldman | Executive Vice President and Senior Policy Advisor

Published October 12, 2016  | September 2016 issue

The Federal Reserve Bank of Minneapolis launched an initiative in 2016 to end the too big to fail (TBTF) problem (described here). Neel Kashkari, the Minneapolis Fed’s president, argued that the problem was not solved as of 2016. And while he noted and supported the efforts under way to address TBTF, he also concluded that these efforts ultimately would not fix the problem. The initiative rests on the idea that now is the time to consider alternative, more transformative solutions.

Virtually all banks in the Ninth District are community banks. I know that people working at, providing services to and owning these banks follow banking-related news very closely. But they could fairly ask, “Does an effort aimed at the very largest banks matter to me?” In this column, I explain why the answer to this question is yes. In particular, efforts to right-size the regulation and supervision of community banks ultimately depend on reducing the chance of large bank bailouts. I expand
on this conclusion after providing a little more detail on the Ending TBTF initiative.

The Minneapolis Fed’s Ending TBTF Effort

The effort starts with concern over the current approach to addressing TBTF. A key component of the current approach is the idea that the government will stick losses on bondholders of large banks during a period of economic and financial stress. Making bondholders absorb the losses from bank failure will, under this plan, eliminate the need for the government to bail out the bank. Kashkari has noted that making bondholders take losses is at odds with what occurred during the most recent financial crisis and during the vast majority of such crises that have occurred in recent history. His view is informed by his direct involvement with the bailout decisions during the last crisis.

So a look at alternative approaches is needed. The Minneapolis Fed is considering a wide range of options, from “break up the bank” proposals to requiring the largest banks to hold much more capital than they do today. A key feature of the effort is engaging the public in considering how to address TBTF. Input directly from the public is requested here. The Reserve Bank has also hosted a series of meetings with experts around the country on options to address TBTF, which have been summarized and can be watched here. Kashkari will release a proposal to address TBTF by year-end 2016.

How Ending TBTF Links to Community Banks

Community banks focus on the families and firms in their areas. Senior managers at many such banks have told me that the post–financial crisis regulatory and supervisory regime is making this focus harder to maintain. Too much time is spent, they report, on compliance efforts that do not always create sufficient benefits for the community to justify the costs.

Policymakers at the Federal Reserve have taken some steps to address this concern. Most recently, Federal Reserve policymakers have suggested that the capital regime for small banks could be simplified. Efforts are also under way to reduce the reporting burden on small banks. I believe that many policymakers are open to further efforts to right-size the regulation and supervision that community banks face.

But concern about the TBTF status of the largest banks is a potential roadblock to improving regulation and supervision of smaller banks. Why? My sense is that some policymakers and elected officials worry about any significant relaxation of supervision and regulation in a period when TBTF remains a problem. They might worry that efforts to address community bank concerns would get linked to efforts to roll back supervision and regulation of the largest entities. Or perhaps the idea of any major change in post–financial crisis supervision and regulation seems premature when the job is not yet completed for the largest banks. Also, the public may not want much change until they are confident that bailouts cannot readily occur again.

There is no guarantee, of course, that completing efforts to end TBTF will lead to more risk-focused supervision and regulation of community banks. But the odds of providing regulatory relief for small banks seem better when concerns about the largest banks have been addressed. This suggests a strong link between the Minneapolis Fed’s Ending TBTF effort and an issue of central importance to community banks.