On Wednesday, the Federal Reserve Bank of Minneapolis proposed a plan for breaking up the big banks. What’s the focal point of the plan? Much more aggressive capital requirements.
Capital requirements 101
“Capital requirements” sounds fancy. But the concept is simple. Every business has a balance sheet. On the balance sheet, you’ll find assets and liabilities. Assets are what the business owns. Liabilities are what the business owes.
If you subtract liabilities from assets, you’re left with equity. In fact, that’s the fundamental equation of accounting:
Assets = Liability + Equity
In some contexts, like banking, we’ll replace “equity” with “capital”. It’s the same thing, just different words.
What then is a “capital requirement”? It’s the minimum amount of capital you need to carry for the size of your asset base. That’s why you see capital requirements posed as percentages. You need to carry X% of assets as capital.
The idea is that, if a crisis emerges, our assets might not be worth what we think they’re worth. The crisis might wipe out some fraction of our assets. Our liabilities aren’t going anywhere. That’s what we owe. So the bigger gap we have between assets and liabilities, the more potential loss we can absorb in a crisis and still meet our obligations.
Not all assets are created equal
What I just wrote is admittedly a gross simplification. But it gives you the gist of what we’re talking about. An important missing detail, though, involves the nature of our assets.
Not all assets are created equal. Some are much more risky than others.
Take cash. It’s nearly bulletproof. No matter what kind of crisis hits, the value of a dollar should remain the value of the dollar. (If a crisis robs us of the value of cash, we have much bigger problems than a bank failure.)
On the other hand, take mortgage-backed securities. If an economic crisis destroys the value of mortgages, then these assets can quickly lose their value. That’s what happened as a prelude to the financial crisis.
Clearly some assets are much more stable than others. Thus, if we set up capital requirements, we want to embrace this fact. If a bank’s assets are predominantly in the form of cash, we don’t need to worry so much. If a bank’s assets are predominantly in the form of exotic securities, we should probably worry more.
That’s why the Minneapolis Fed plan specifies the capital requirements in terms of “risk-weighted assets”. Modern banking regulations acknowledge that we need to account for how risky the bank’s assets really are.
How would these requirements break up the big banks?
The Minneapolis Fed plan would only ramp up capital requirements for the biggest banks. Specifically, the plan targets banks with assets greater than $250 billion.
Which banks qualify? JPMorgan Chase. Wells Fargo. Bank of America. Citibank. Each of these has over $1 trillion in assets.
The incentive for a big bank to break up is that it’s easier to be profitable if your capital requirement is lower. Higher capital requirements mean you have a larger fraction of safe assets. When you think of risk versus return, “safe” means low return.
Smaller banks could be more aggressive. They could have a larger fraction of their assets in risky classes. They would still face some regulation, and have to survive under some capital requirement. But the capital requirement would be considerably less strict than it is for big banks.
Why are big banks more dangerous than small banks?
In a lot of cases, we think of large businesses as stronger, and more stable, than small businesses. We think of companies like DuPont, General Motors, General Electric, 3M, et cetera. Each of these has been around 100 years or more. Surely their huge size is a huge advantage.
Maybe. But maybe not. One person clearly lines up on the side of large companies being more risky: Nassim Taleb, author of The Black Swan. Here’s what he says in one of his other books, Antifragile (p. 332):
Corporations that are large today should be gone [in the future], as they have always been weakened by what they think is their strength: size, which is the enemy of corporations as it causes disproportionate fragility to Black Swans.
In this context, a Black Swan is a rare, unforeseen, consequential event…like an economic crisis. Taleb’s argument is that large corporations are more susceptible to these kinds of events, which makes big banks more dangerous than small banks.
Why should that be the case? Shouldn’t a big bank have an asset base like a small bank, just more highly diversified? That’s an easy way to picture it, but that’s not what happens.
A big bank’s balance sheet is not like the sum of the balance sheets from 20 small banks. A big bank places large bets that small banks can’t place. A big bank enters financial relationships with big insurance companies and other big banks.
Big institutions interact with each other in unique ways, creating networks that transmit risk through our entire economy. Big banks can cripple the system in ways that even larger numbers of small banks can’t.
The Minneapolis Fed plan sounds extreme. I don’t think it goes far enough
Neel Kashkari is the president of the Minneapolis Fed. If you read the financial press, you might think Mr. Kashkari is nuts. The media, at times, makes him sound like a Bernie Sanders-loving lunatic.
He served under George W. Bush and Barack Obama as administrator of the Troubled Asset Relief Program (TARP). He ran for California governor in 2014…as a Republican.
He worked for Goldman Sachs and earned his MBA from the Wharton School at the University of Pennsylvania. The dude is legit. He knows the banking system as well as anyone alive.
The Minneapolis Fed estimates that, under current regulations, we have a 67% chance of requiring another bank bailout in the next 100 years. Under their new plan, the Minneapolis Fed estimates those chances should drop to about 9%.
But if you’re with Nassim Taleb, you know that, if anything, we underestimate the chance of consequential tail events like economic crises. Our analytical models are distorted. They assume much more regular, predictable behavior than we actually see in the world. We’re more prone to disaster than we think. That’s why we have to be prudent when it comes to big banks.
What would I do? Impose even stricter capital requirements on the largest banks. I’d even consider regulations that cap the size of any given banking institution. Further, I’d entertain the idea of nationalizing banks.
In the vast majority of industries, the profit motive makes the world a better place. Companies are incentivized to deliver the best products and services at the best prices to the largest number of customers. For a bunch of reasons, I think the profit motive skews the behaviors of banks, relative to the social good they do. But that’s another post for another day.