Big Banks: Still Too Big To Fail? by Fran Reed, FactSet

A surprising new voice has emerged in the “too big to fail” debate: a Federal Bank Reserve President. Minneapolis Fed President Neel Kashkari this week publicly advocated for breaking up the big banks, asserting that the 2010 Dodd-Frank Wall Street Reform Act didn’t go far enough. He rationalized that despite banking’s long effective lobbying efforts to block structural change combined with the post-crisis fragile economic environment, the economy is now sufficiently strong to support bold bank break-up action. His comments could influence decisions over big-bank policy, both on Capitol Hill and among regulators.

Mr. Kashkari is the Fed’s newest bank president (one month in office) and a Republican who served in the George W. Bush White House administration. Importantly, he’s also a former top Treasury Department official, who during the financial crisis ran the government’s $700 billion Troubled Asset Relief Program (TARP), the 2008 crisis-related effort to stabilize the financial system by injecting capital into banks. Unlike other Fed bank presidents, he also is a former politician, having run unsuccessfully as the Republican candidate for governor of California in 2014.

Mixed Messages

Fed Chair Janet Yellen testified on February 10 before the joint House Committee on Financial Services and Senate Banking Committee, the required semi-annual Monetary Policy Report to the Congress (formerly known as Humphrey-Hawkins Testimony), that regulatory efforts in the wake of the financial crisis have been effective in creating a more resilient and stronger, better-capitalized, more liquid banking system.

All of this has taken place during a tumultuous U.S. presidential primary season in which both liberal and conservative candidates have been sharply critical on the lasting effects of the financial crisis. Democratic presidential candidate Senator Bernie Sanders has been firing up audiences by attacking “Wall Street’s greed” and several Republican candidates have vowed to repeal “heavy-handed” governmental regulations.

Big Banks – If a Bank is Well Capitalized and Less Complex, Does Size Really Matter?

Size alone is a simplistic and arbitrary measure. It’s true that the biggest banks have grown bigger. According to the Federal Deposit Insurance Corp. (FDIC), by year-end 2015, the big four U.S. banks (JPMorgan, Bank of America, Citibank, and Wells Fargo) had combined assets equal to 51% of the $5.18 trillion total bank assets — compared with 44% of the $8.01 trillion total bank assets at the end of 2006.

Most current policy makers haven’t endorsed breaking apart large banks. The generally held belief is that the 2010 Dodd-Frank financial-overhaul law and the actions that followed it outlawed bailouts and are forcing bank creditors and investors to assume the risk of a big bank failure, rather than taxpayers.

Regulators like the Fed, the ECB, the Basel Committee on Banking Supervision (Basel III), and Financial Stability Board have taken dramatic micro-prudential actions limiting bank risk-taking through higher capital requirements, the threat of capital surcharges for non-compliance, and greater loss reserve requirements.

  • Core tier one capital ratios: a key measure of a bank’s balance sheet strength, comparing equity capital to risky assets.
  • Leverage coverage ratios: measures capital held by banks against total assets
  • Total Loss Absorbency Capital (TLAC): capital buffer requirements to absorb potential losses

Regulatory pressure on large banks to increase capital cushions to absorb potential losses and reduce reliance on volatile forms of funding have helped fortify their balance sheets, but the extra capital set aside for losses has dragged down profits and price performance.

Big Banks

Shadow Banks

Importantly, two bank industry trends of the late 1990s and early 2000s set the stage for the financial crisis: an over-reliance short-term funding combined with a new way to leveraged long-term complex risk.

  • Short-term funding: Through the issuance of asset-backed securities (ABS) and asset-backed commercial paper (ABCP), banks became addicted to a huge new source of short-term funding from wholesale sources like institutional investors. The great irony in wholesale funding sources is their abundant availability in good times but total loss in tough times. Harder-to-come-by retail deposit bases proved to be a much more stable source of funding.
  • Leveraging complex risk: The special purpose vehicle (SPV) created the ability to securitize mortgage collateral from illiquid assets into tradable securities. Banks would sell large groups or “pools” of geographically diverse loans to these SPVs, which had no employees or physical location and were not subject to banking regulation. SPVs financed their risky asset purchases by issuing short-term paper into the capital markets, acting similar to banks (“borrow short, lend long”) — which is why SPVs are referred to as “shadow banks.”

Securitizations were broken down into “tranches” with varying expected cash flows to receive a certain credit rating, which allowed banks to distribute this new form of risk to investors who desired specific exposures; higher returns were given to riskier expected cash flow tranches. Credit ratings were assigned by expected cash flow analysis and not by the credit worthiness of the borrower.

Ultimately this standardization and growth of the securitization process led to lower mortgage lending rates and, in turn, led to reduced lending standards. In reality, banks retained large amounts of this risk. The majority of securitization never really left the banking system and ironically increased the interconnectedness among banks.

Modern Regulations

The post-financial crisis regulatory regime has been crafted to take more than size into account. Supervisors assess the strength of the banks by considering four elements:

  • Business model
  • Governance and risk management
  • Risks to capital
  • Risks to liquidity and funding

Complexity and liquidity risks are at the heart of modern banking reform. There’s been sharp regulatory focus on simplifying banks: streamlining the legal entity structure and providing incentives for higher quality liquid assets (HQLA) and lower risk-weighted assets. The new regulatory framework has gone a long way to imposing costs on big banks based on the risks they pose to the financial system. The flaw is that this framework hasn’t made clear what the endgame is. The implicit message of capital surcharges and other constraints is that banks of a certain size and risk profile will be treated as utilities.

Although today’s big banks may be bigger, they are less interconnected, less complex, maintain stronger balance sheets and generally have far smaller derivatives books.

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