New Minneapolis Fed president says 'too big to fail' still a major problem in banking

Neel Kashkari opened his tenure as president of the Federal Reserve Bank of Minneapolis by sounding the alarm that the massive banks that brought the global economy to its knees in 2008 could do so again.

"I believe the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy," Kashkari told an audience at the Brookings Institution in Washington, D.C.

By diving deep into the regulations needed to avoid another taxpayer bailout of the financial industry, Kashkari made an abrupt departure from the interests of his predecessor, Narayana Kocherlakota, who focused most of his public statements on interest-rate policy.

In his first speech since taking over the Minneapolis Fed last month, Kashkari looked to spark a fresh examination of the "too big to fail" problem and floated some of the most extreme options for solving it: breaking up large banks into smaller, less connected, less important entities; turning large banks into public utilities by forcing them to hold so much capital that they virtually can't fail, and taxing leverage throughout the financial system to reduce systemic risks wherever they lie.

"Options such as these have been mentioned before, but in my view, policymakers and legislators have not yet seriously considered the need to implement them in the near term," said Kashkari, who ran the government's bailout of the financial sector during the 2008 crisis. "They are transformational, which can be unsettling."

Kashkari is a former Goldman Sachs banker who, as a Treasury Department official in 2008, constructed the rescue plan for the nation's banks following the collapse of Lehman Brothers and the seizing up of the credit markets.

His audience at Brookings included former Fed Chairman Ben Bernanke, who oversaw the 2008 rescue, along with other former officials. Some have argued that government actions, particularly the 2010 Dodd-Frank financial industry oversight law, have substantially reduced the risk that taxpayers would ever have to rescue big banks again.

Kashkari said that progress hasn't been enough.

"No rational policymaker would risk restructuring large firms and forcing losses on creditors and counterparties using the new tools in a risky environment, let alone in a crisis environment like we experienced in 2008," he said. "They will be forced to bail out failing institutions — as we were."

Progress has been made by forcing banks to hold more capital, undergo stress tests and create "living wills" that outline how they would be restructured in the event of a collapse.

But Kashkari said his experience in the financial crisis taught him that there is no simple formula for determining which institutions are systemically important to the economy. It depends on how healthy the economy is, and the next crisis will arrive unannounced, looking unlike anything policymakers are expecting.

He likened a large financial institution to a nuclear reactor. The costs to society of meltdown are "massive," and governments must do whatever they can to keep them from collapsing.

"We know markets make mistakes," he said. "That is unavoidable in an innovative economy. But these mistakes cannot be allowed to endanger the rest of the country."

Kashkari said he is not sure the current system of capital requirements, stress tests and living wills can handle the collapse of one institution, let alone several in a weak economy. He argued that Congress should create "bold, transformational solutions to solve the problem once and for all."

In a rollicking panel discussion with former Minneapolis Fed President Gary Stern, former Fed Governor Donald Kohn and former journalist David Wessel, Kashkari demonstrated just how different he is from most Federal Reserve officials. He sparred in clear language with Stern and Kohn, who both said they believed the work done since the financial crisis has at least partly solved the problem.

Kashkari quoted Gen. Norman Schwarzkopf in comparing the chaos of a financial crisis to war. He drew a parallel between regulatory responses to past problems and the Transportation Security Administration's requirement that air travelers remove their shoes at security checkpoints.

But he also noted that a blanket prohibition on bailouts isn't a good idea, either, in the same way that it wouldn't be smart to take hoses away from firefighters in response to a proliferation of forest fires.

Asked by Wessel what led him to wade into such provocative territory, Kashkari said he wanted to take on big challenges at the Minneapolis Fed.

"When I got to the bank, I found a lot of expertise on too big to fail, on large banks and on bank regulation," he said. "I started talking to the experts and testing some of my ideas, some of my assumptions. I realized, wow, there are still big risks here. Financial stability, that's one of the Fed's missions. If I'm not willing to stand up and share my concerns, then I'm not doing my job."

He said that the Minneapolis Fed would build on its work at the forefront of understanding the risks of large banks and the work done nationwide since the crisis and that it would hold a series of symposiums on "too big to fail," starting this spring. He hopes to develop a plan that the bank will deliver by the end of the year. The bank has set up a website and will take suggestions from any expert with a good idea.

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