Minneapolis Fed: Reining in big banks could spur shadow lending

The Minneapolis Fed's latest dive into the problem of "too big to fail" banks on Monday looked at an obstacle: fixing them could expand the shadow banking system.

It's one of the unintended consequences that policymakers and economists most fear if big banks are broken up, that too much lending will wind up with unregulated financial institutions and create a new risk for the economy.

"While I think the shadow banking system is way less of a threat than it would have been in 2005, I do still worry about the possibility for risk to migrate back to shadow banking," said Samuel Hanson, a professor at the Harvard Business School.

Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, said Monday that he and his staff are on track to release policy recommendations before the end of the year for how to eliminate the possibility that massive financial institutions could bring down the global economy.

The daylong event Monday at the bank was the fourth and final symposium in the initiative, which Kashkari launched in February and has defined his first year at the helm of the Minneapolis Fed.

The morning panel discussion covered different ways to hold creditors responsible for the loans they have made to failing institutions. The afternoon was geared toward understanding the implications of greater regulation on large banks and non-banks.

Kashkari sought to return to the central questions of his initiative: How to regulate banks down to a manageable size, and what the collateral damage of those regulations might be.

If lending from a very large bank moved to a couple of small banks as a result of migration, Kashkari asked Hanson, doesn't that reduce systemic risk?

"If it was activity migrating from a $2 trillion bank to a couple of $50 million banks, totally," Hanson said.

But some of the activity would migrate to non-banks, and both Hanson and Morgan Ricks, a law professor at Vanderbilt, said they are more worried about the money-creation role the shadow banking sector plays by buying and selling a lot of short-term debt.

Responding to Hanson's idea that the government should issue more short-term debt to discourage that activity, Viral Acharya, an economist at New York University, said he feels uncomfortable with the government getting involved in buying and selling debt to "crowd out" non-banks.

"It's better to get at financial stability directly, in my view, rather than mixing fiscal policy with it," Acharya said.

Ron Feldman, the vice president at the Minneapolis Fed who moderated the discussion, was by then looking to end it, and landed on a good segue.

"So that's a good setup for the debate tonight, perhaps," he cracked.

Kashkari wrapped up by reiterating his belief that current regulations do not correct for past mistakes, and they give him no confidence they will correct for future mistakes. "At a minimum, the regulations should at least correct the past mistakes and then hopefully they'll have some effect going forward," Kashkari said.

Adam Belz • 612-673-4405 Twitter: @adambelz