The Financial And Economic Impacts Of Allowing The Federal Reserve To Direct America's Economy

Neel Kashkari is on a mission.

The Minneapolis Federal Reserve, led by Kashkari, released a detailed strategy Wednesday that outlined a plan to raise capital requirements for the largest banks, such as Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM) , while reducing the burden faced by the smaller banks.

According to the Minneapolis Fed, current capital requirements place undue risk on taxpayers of a future crisis and possible need for a bailout. The plan stated that the goal is a "financial system that enables the U.S. economy to flourish without exposing it to large risks of financial crises or without requiring taxpayer bailouts."

Enacting the plan to end "too big to fail," or TBTF, would reduce the 100-year chance of a crisis to 9% from its current 67%.

"Banks would be less profitable if they had much higher capital requirements -- the more risk the taxpayers take the higher are bank profits," Kashkari told TheStreet in an interview. "This plan would absolutely constrain the return on equity at the largest banks and that would likely affect their share prices."

Under the regulations enacted following the financial crisis in 2008, the 100-year chance of a bailout was reduced to 67% from 84%. Kashkari noted that today's strong economy enables the subsequent strengthening of the U.S. financial system. Waiting for the next financial crisis to occur would be too late.

TheStreet talked with Kashkari, a prominent government officical during the Great Recession, about the new research and outlook for the financial system. 

Neel Kashkari unveils some serious new research.
Neel Kashkari unveils some serious new research.

TheStreet: This is a radical approach to ending too big to fail. Why was it so important for you to release this?

Kashkari: I feel as though our jobs at the Federal Reserve, and the Federal Reserve banks, are to look out for risks in the economy, identify them hopefully in advance and propose sensible solutions. The financial crisis is burned into me from my experiences back in 2008 and 2009. That time was so devastating to the U.S. economy that none of us want to allow something like that to happen again. The fact of the matter is that the biggest banks in America are still too big to fail. If they ran into trouble today taxpayers would still be on the hook. The American people would need to know that. 

So we have spent two years doing this work convening the best experts in the world, receiving comments, fine-tuning the analysis and the biggest banks are still too big to fail. This is the best approach to address this. It addresses it in a sensible manner, and the benefits of this plan far exceed the costs. 

TheStreet: Why are the powers that be too scared to end too big to fail?

Kashkari: Well, it could have been done back in 2009 and 2010 when Dodd-Frank was being negotiated. But the concern was that the economy was so fragile at that point that the recovery was uncertain, the legislators at the time said, "Let's just keep the financial system intact and put some belts and suspenders around it." 

But here we are almost 10 years later and the economy is on much stronger footing. I think now is the time to act with the economy strong, but before we have forgotten how painful the 2008 crisis was. 

TheStreet: Let's say your plan hypothetically gets implemented tomorrow. How do you think the markets and banks respond?

Kashkari: I think several of the large banks choose to restructure themselves radically due to these higher capital requirements. The banks like to claim that they have these great economies of scale but then they say if you raise our capital requirements, we won't be profitable anymore. Then you have to ask if they really have these great economies of scale? I think they don't. 

My sense is that many large banks will choose to restructure themselves so that they are no longer too big to fail. Those that decide to maintain their current scale, that's because their business model could support higher capital requirements. Banks can't have it both ways. 

TheStreet: So when you say banks would structure, does that mean they would be forced to combine or merge?

Kashkari: No, the opposite. I think much more likely is that they would spin off different business lines to try and get out of these higher capital requirements. But rather than government bureaucrats deciding to restructure banks, we are letting the market decide what is the optimal structure for banks given the capital requirements we have outlined. 

TheStreet: Bank investors have seen a nice rally over the last few months. But if they look at this plan, should they be worred about fewer profits?

Kashkari: I think that is right. Banks would be less profitable if they had much higher capital requirements. The more risk the taxpayers take the higher are bank profits. It's their direct interest to put as much risk on the taxpayers as possible and to lever up as much as possible. This plan would absolutely constrain the return on equity at the largest banks and that would likely affect their share prices. 

But that's not my concern. Obviously the political winds are blowing against us right now, but that doesn't mean we shouldn't speak out and identify solutions.

TheStreet: Does enacting this plan, for instance, trickle down and impact the M&A market as banks take less risk?

Kashkari: I doubt it. Maybe the M&A market for the banks. But I don't think it would have an affect on the M&A market for corporate America. They can already borrow very cheaply. Our cost benefit analysis looks at if we raise the capital requirements on the biggest banks, and that then affects lending rates and costs in the economy, that's the cost of the plan. The plan is not free. But the benefits of avoiding a 2008 crisis far exceed the economic cost of raising the capital requirements on the biggest banks. 

Importantly, we also relax legislation on small and mid-size banks because they are not systemically risky. We would expect some of those banks to fill the void with the biggest banks potentially pulling back. 

TheStreet: Everyday it seems as it bitcoin prices and tech stock prices are going up. Are we sowing the seeds of the next financial crisis looking at how hot many assets are right now?

Kashkari: We at the Fed are keeping our eyes open for signs of crisis building. It's important to distinguish when the tech bubble burst in 2000 it wasn't devastating for the U.S. economy -- it led to a minor recession and investors faced losses. That's a normal correction that takes place in a market economy. Contrast that with 2008 when the housing bubble burst that led to economic devastation. 

What's the difference? There is much more leverage under the housing market than under the stock market. Investors in the stock market are maybe up to 1:1 leverage. With housing, people put nothing down so they may be 20:1 leveraged. We think that debt under the housing market makes things potentially problematic if there is a major correction. 

We at the Fed don't see signs of a 2008 crisis brewing. But at the same time if you look at history, excesses are built up, there are mass hysteria events or exuberance and those things burst and lead to crises. Our plan wants to protect the economy and taxpayers for whenever the next event happens. I'm not predicting it in the next few years, but I am predicting it in the next 50 years. 

TheStreet: What does that next crisis look like?

Kashkari: This is what we need to admit: We have no idea. Here's an example: No one at the Fed or anyone I know predicted oil prices going to $140 down to $30 and back to $60 -- that's a huge economic shock that has huge implications for the U.S. and global economy. We completely missed it. It didn't lead to economic devastation, it was a normal fluctuation in a market economy. 

TheStreet: What has been the feedback from your friends in the banking community to this plan?

Kashkari: They hate it. They are furious. I have friends of mine that are very frustrated that I did this work. My response to them is that I wouldn't be doing my job if we weren't speaking out about risks that we see and coming up with solutions, even if they are unpopular. 

I think the banks will take every opportunity to take their shots at us. But the best news over the past year during the comment period is that nobody has been able to poke holes in our analysis. 

TheStreet: Have you talked to Treasury Secretary Mnuchin about this?

Kashkari: I have not. 

TheStreet: How likely is it that this plan gets implemented? How long could it take?

Kashkari: I think it could take a few years. The winds are blowing against us. But there are elements of this plan that appeal across the aisle. Our plan addresses too big to fail and relaxes regulations on small to mid-size banks. That resonates with Republicans and Democrats. 

But change doesn't always happen in a linear manner. Sometimes change doesn't happen until everything moves. 

TheStreet: What's your sense of the stock market right now?

Kashkari: I think the markets are pricing in a lower long-term interest rate environment, which is not actually under the control of the Fed. To me, that explains some of where asset prices are today. But again, if there is a correction so what -- investors will face some losses, that happens in a market economy. We don't see impending signs of a financial crisis. Could there be a correction? Sure. But it's not the Fed's job to protect investors from losses. 

TheStreet: Are investors under-appreciating this recent spike in bond yields?

Kashkari: I think we are all paying attention to it. I have been saying for the last few years that inflation keeps coming in lower than the Fed's 2% target. I am looking for signs of actual inflationary pressures building. If the bond market is telling us inflation is building, then we will pay attention to that. 

I also want to look at the actual measures of inflation, both CPI and PCE, and see if it's bleeding through to wages and ultimately into prices for businesses. 

TheStreet: Give us a sense of incoming Fed chief Jerome Powell.

Kashkari: I have dealt with Jay a lot the past two years and find him an outstanding colleague. Very thoughtful and smart. He takes the work of the Fed very seriously. I think he is a great choice. I have a lot of confidence in Jay Powell. 

TheStreet: How might he be different than Chair Janet Yellen, say, during his post-FOMC decision press conferences?

Kashkari: No examples to think of. I think that his five years at the Fed under Ben Bernanke and Janet Yellen, it was great training for him. I am not anticipating any big changes. 

TheStreet: Are cryptocurrencies a real threat to the U.S. dollar?

Kashkari: I don't find cryptocurrencies a credible competitor to the dollar. Here is the fundamental flaw. The advocates of bitcoin said, Hey, you can trust bitcoin because we are only ever going to mine X number of bitcoins." It's constrained in its foundation. That may well be true. But the barrier to entry in all these alt-coins is zero. I can create Brian Coin or Neel Coin and all of a sudden you have inflation in cryptocurrencies that are indistinguishable from one another.

Think about gold. Why has it had this role in the economy for thousands of years? You can't just create gold. The Earth created gold and there is only so much of it. It's that scarcity that gives currencies value. When you think about the dollar, it's created by the the federal government and it has a monopoly on creating U.S. dollars. 

So cryptocurrencies will never be credible competitors because the barrier to entry is so low. I would stick with the dollar. 

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Source : https://www.thestreet.com/story/14444544/1/federal-reserve-neel-kashkari-new-bank-research.html

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