Ending Too Big to Fail - Fourth Symposium Summary

November 16, 2016

The fourth and final symposium hosted by the Federal Reserve Bank of Minneapolis was held on September 26, 2016. Progressing toward the goal of releasing a policy plan to end too big to fail (TBTF) by the end of the year, the symposium explored additional challenges and solutions to the persistent problem of TBTF.

Two panel discussions were held, the first focusing on whether debt issued by banks—such as “bail in” bonds required under a current Board of Governors proposal—can effectively recapitalize banks in the resolution process. The second panel discussed the growth of the shadow banking industry in response to the asymmetrical regulatory framework of banks and nonbanks.

This fourth symposium also featured a keynote speech by Roger W. Ferguson, Jr., who shared views on financial regulation based on both his current role as president and CEO of TIAA and his prior role as governor and vice chair of the Board of Governors of the Federal Reserve System.

Panel 1: Converting debt to equity as a means to address TBTF

The panelists,1 coming from a wide range of backgrounds and perspectives, made key points, which include but are not limited to the following:

  • Bank equity is the best tool to absorb losses because shareholders absorb losses from insolvency.
  • Panelists noted the challenge of converting debt to absorb losses from bank failure. In general, panelists noted that supervisors have not done a good job of forcing banks to get new capital before they suffer deep losses, at which point it is difficult to recapitalize the bank without public funds.
  • This general problem is present in the so-called total loss-absorbing capacity proposal, which counts on government taking unpopular action at an ill-defined point. Thus, some panelists thought that TLAC has been vastly oversold as a solution to TBTF.
  • An alternative view presented is that the provision of a resolution regime, combined with some debt to convert to equity, does make it less likely that firm creditors get bailouts and thus does address TBTF.
  • The political pressure against acting will be very large if the perception is such that action can lead to more instability.
  • The panel discussion also suggested that requiring government to shut down banks when equity is still positive would be a move to forcing more timely action.

Roger W. Ferguson, Jr., Keynote: Financial regulation from the viewpoint of the regulated

Roger W. Ferguson, Jr.,2 began his remarks by commending the work of the TBTF symposium series for its exploration of resiliency in the broader financial system. He went on to note that these discussions usually look at regulations from the view of the regulator; but from his post-2008 experience after leaving the Federal Reserve System, Ferguson shared his current perspective of leading TIAA, a regulated insurance institution.

  • Ferguson analyzes regulations through a prism of an organization predominantly engaged in insurance. From this viewpoint, he emphasizes the importance of exercising restraint in imposing bank-centric frameworks upon nonbanks. Rather, regulators should recognize that insurance-centric firms have a different business model, structure, and role than banks.
  • The primary policy goal is to ensure that there is a resilient financial system to stress. Financial resilience should be achieved by having an ecosystem that is not monolithic, but has many different components that serve to maintain the “diversity of the financial eco-system.”
    • Of course, the system needs to be safe and sound. Additionally, it needs to minimize the creation and propagation of spillovers.
  • To achieve the overarching goal of financial resilience, the TBTF problem must be addressed though a nuanced approach that recognizes the differences in various institutions and does not treat them with a one-size-fits-all approach.
    • Ferguson emphasized this as his primary point, noting that an approach that treats all firms in a monolithic fashion could end up making the system less stable.
  • Banks and nonbanks, like insurers, engage in fundamentally different businesses, with different business models, balance sheets, and customer value propositions. These distinctions drive the rationale for having different regulatory frameworks applied to each.
    • At its core, banking activity remains lending and maturity transformation—connecting savers to borrowers. In contrast, insurers allow customers to reduce their exposure to risk.

Panel Two: The potential for risk to shift to the shadow banking sector in response to banking regulation and the appropriate regulation of shadow banks

The panelists3 discussed how modern firms are responding to asymmetry in regulatory frameworks. The current regulatory framework is effective in an environment where banks and nonbanks (shadow banks) engage in a separate set of activities. Now, with the lines of activity blurring and shadow banks engaging in a higher volume of activity that was once the domain of the traditional banking sector, the differentiation between bank and shadow bank activity is less defined. This panel discussed this development and potential government responses. Key points include, but are not limited to, the following:

  • Whereas traditional banking is characterized by highly regulated institutions that receive extensive public support (e.g., deposit insurance and lender of last resort), shadow banking is characterized by chains of transactions involving multiple intermediaries that are lightly regulated.
  • Heightened regulation leads activity to migrate from regulated banks toward shadow banking or other more lightly regulated nonbank intermediaries. This potential for migration reduces the ability of regulation to correct underlying market failures and safeguard financial stability.
  • Instead of the current practice where regulation is imposed upon certain types of institutions, several panelists suggested that financial regulation be activity-based.
  • On the liability side, the issuance of debt by shadow firms, particularly short-term debt, presents concern by making these firms vulnerable.
  • On the asset side, the concern focuses on assets that would take losses in a fire sale, which are also the assets that are the hardest to price and value.
  • The flow of activity and potential risk from the banking to the nonbanking sector is a real threat. Intense regulation of banks makes it more costly to engage in these activities in the banking context. So the activities move to the shadow sector, which does not impose the same level of intense regulation. This leads to the types of liabilities and assets of concern being more present and important in a growing shadow sector.
    • For example, some panelists mentioned reports of loans moving from banks to the nonbanking sector, funding by debt.
  • Panelists discussed options for government response to this threat of activity migration from the banking to nonbanking sector.
    • One panelist called for a prohibition on the issuance of short-term debt by any financial firm that is not a bank.
    • Another idea included crafting new regulations to address the migration phenomenon.

Endnotes

1 Panelists included Emilios Avgouleas, Professor (Chair) of International Banking Law and Finance at the University of Edinburgh and a member of the stakeholder group of the European Banking Authority; Mark Flannery, Director and Chief Economist at the U.S. Securities and Exchange Commission and BankAmerica Eminent Scholar in Finance at the University of Florida; Stuart Plesser, Senior Director in S&P Global’s North American Financial Institutions Ratings Team; and Larry Wall, Research Center Executive Director of the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta.

2 President and Chief Executive Officer of TIAA and former Vice Chairman of the Board of Governors of the Federal Reserve System.

3 Panelists were Viral V. Acharya, C. V. Starr Professor of Economics at New York University Stern School of Business; Samuel Hanson, Associate Professor of Business Administration at Harvard Business School; and Morgan Ricks, Associate Professor of Law at Vanderbilt Law School.