Fed's Kashkari says higher capital requirements would bolster banking system

After the high-profile failures of Silicon Valley Bank and Signature Bank, Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, says requiring banks to have higher capital levels could be the best solution to addressing the underlying weakness in the banking system.

"[It's] our only chance to build real resilience in our financial system," he said in an essay published Monday on the Minneapolis Fed's website.

Kashkari reflected on the three massive government interventions in financial markets in the past 15 years: the financial meltdown of 2008, the 2020 response to the COVID-19 pandemic and the bank collapses earlier this year, including most recently the failure of First Republic.

"Can't we do better as a nation?" he wrote.

As regulators consider making changes to bolster the system, he cautioned against making the same previous attempted fixes, such as relying on hiring more staff and developing smarter stress tests.

"We should assume that managers, boards, supervisors and policymakers of the future will continue to make mistakes, as they have in the past," he said. "We can design a regulatory system that will withstand this inevitable human failure."

While it is difficult to predict the next shock, he suggested having sufficient capital can protect against virtually any scenario.

Kashkari was a senior Treasury Department official during the 2008 financial crisis and was an architect of the resulting big-bank bailout. Since then, he's been a critic of the biggest banks being too big to fail and has pushed for higher capital requirements.

A year after he arrived at the Minneapolis Fed in 2016, the bank released a proposal known as the Minneapolis Plan, which recommended the nation's largest banks should significantly increase their capital levels by up to nearly 40%. But the plan gained little traction at the time.

In an appearance on CNBC on Monday, Kashkari acknowledged requiring banks to hold more capital would mean they would not be able to lend as much.

"It's not costless," he said. "Like everything, there's trade-offs."

He added he has not yet seen evidence of the stress in the banking sector affecting his region, including Minnesota. But he said it remains to be seen whether it does have an impact on inflation.

That's why he could be open to the pausing on interest rates next month.

"I think right now, it's a close call either way versus raising another time in June or skipping," he said. "Important to me is not signaling that we're done."

Kashkari has a vote this year on the Fed's rate-setting committee.

In his essay, he nodded to a number of analyses that have concluded capital levels in the banking sector, while higher than they were in 2006, are not high enough to balance the significant costs of financial crises.

"If SVB, Signature and First Republic had significantly more equity capital, their depositors would have been reassured because the banks could have absorbed their mark-to-market losses," he wrote. "Higher capital levels can both address the too-big-to-fail advantage of the largest banks (which stunningly tend to have much lower levels of capital than small banks have) and can reduce the complexity of our regulatory apparatus."

He added banks don't like higher levels of capital because it can hurt their stock prices, and they will likely fight it. And regulators might try to avoid that fight with bankers.

"I urge us to have the courage to take the hard path and address the underlying fragility of the banking sector," he said.