It was clearly unintentional, but the Minneapolis Fed showed why transparency is the preferred solution for ending Too Big to Fail and financial crises.  Transparency is the superior solution because it both prevents financial crises in the first place and it doesn’t restrain economic growth.

Throughout most of 2016, the Minneapolis Fed has been looking at how to end the problem of Too Big to Fail banks.  Naturally, I reached out and offered to talk about how transparency would solve this problem.

I was rebuffed.

When I observed on Twitter the failure to invite me rendered the Minneapolis Fed’s efforts a complete waste or at a minimum a failure to consider all of the alternatives, Neel Kashkari, the President of the Minneapolis Fed responded:

Neel Kashkari ‏@neelkashkari Sep 27 Minnesota, USA
@chadstarliper @tyillc lots of people have their angle. If their angle isn’t the focus, everyone else’s work is useless. Sorry. Don’t agree.

Despite this exchange, even when introducing the results of the Minneapolis Fed’s efforts, he continued to maintain it turned over every rock and talked to every expert:

Our initiative brought together a wide range of experts on financial crises and banking regulation through a series of symposiums in Minneapolis and Washington, D.C. By design, we wanted to hear all views….

Expert participants in our symposiums included former policymakers such as former Federal Reserve Chairman Ben Bernanke, Vice Chairman Roger Ferguson, and Governor Randy Kroszner. They included leading academics, such as Anat Admati of Stanford and Simon Johnson of MIT, among many others. They included policy experts from think tanks, such as Adam Posen of the Peterson Institute and Aaron Klein of the Brookings Institution. And they included economists currently working at policymaking institutions, such as Giovanni Dell’Ariccia of the International Monetary Fund (IMF) and Mark Flannery of the Securities and Exchange Commission. At every symposium, we invited the private sector to participate and were pleased to hear from experts across several segments of the financial services industry…

Despite the fact you didn’t want me to participate, Neel, I owe you an apology.  The Minneapolis Fed’s work wasn’t completely useless as I had said it would be.  In fact, it is very important.

Why is it important?

It should end forever academics and regulators talking about bank capital as a solution for ending the problem of Too Big to Fail banks.

Wait a minute!  The Minneapolis Fed’s plan is to make banks hold more capital the bigger they get.  As a result, banks are given an incentive not to grow in size until they become Too Big to Fail.  In addition, the currently Too Big to Fail banks are given an incentive to shrink themselves so they are no longer Too Big to Fail.

I actually think the plan could and should work.  I would be highly supportive of the Minneapolis Fed’s plan were it not for the cost to the economy of pursuing the plan’s benefits.

In his speech introducing the plan, Mr. Kashkari provided the following table showing the benefit of the plan as a reduction in the chances of a once in a 100 year financial crisis and cost as a reduction in gross domestic product.

Table 1:  Evaluating the Minneapolis Plan

Chance of bailout (next 100 years)   Overall Cost (% of GDP)

2007 Regulations                                          84%                                                         0%

Current Regulations                                     67%                                                        11%

Minneapolis Plan

Step 1                                                         39%                                                         24%

Step 2                                                      >=9%                                                    <=41%

Typical cost of a banking crisis                                                                            158%

The row that caught my attention shows adopting the strongest version of the Minneapolis Plan only lowers our chances of avoiding bailing out a Too Big to Fail bank to slightly less than 10%.   Then I looked at the cost of achieving this reduction in the chances of a bailout.  Mr. Kashkari described how to interpret the cost figure:

Here we calculate the present value of future costs, using a similar method as do regulators around the world….

Here we see that the Bank for International Settlements’ consensus estimate for the typical cost of a banking crisis is 158 percent of GDP, which for the U.S. economy equals roughly $28 trillion. This is the present value of the long-term effects of a banking crisis. As we have seen since the recent crisis, the U.S. economy has been growing much more slowly than had been previously expected. These long-term effects are fairly typical for financial crises, which as you can see, are extraordinarily costly for society.

Fair enough, but let the 40% of GDP number sink in for a second.  It is the present value of the annual reduction in GDP caused by adopting the Minneapolis Plan.

So what is this annual reduction in GDP?  According to Table 4 in Section 3.1.3 of the full plan, the annual reduction in GDP is 1.41%.

To put this annual reduction in GDP in perspective, consider over the last 150 years GDP in the US has grown on average by 2%.

The Minneapolis Plan would reduce the expected growth in US GDP over the next 100 years by 70%!

Said another way.  Using the rule of 72, we would expect US GDP to double every 36 years (72/2).  Roughly speaking this means in 100 years US GDP should be 8 times larger than it is today.  If the Minneapolis Plan is adopted, we would expect US GDP to double every 120 years (72/(2-1.41)).  Roughly speaking in 100 years US GDP should be not quite 2 times larger than it is today.

By comparison, let’s look at requiring transparency.

By definition, requiring transparency reduces the odds of bailing out a Too Big to Fail bank to 0.

Why? Investors know where they have transparency so they can know what they own they are responsible for all losses on their exposures.  As a result, there is no need to bailout investors in non-quaranteed bank debt or bank stock.  They know to limit their exposure to what they can afford to lose.

So what is the cost of transparency?

Effectively zero (it would be absolute zero if not for the de minimis data processing cost).

Earlier, I said the Minneapolis Plan should forever end any more discussion by regulators, academics or any other experts on bank capital as a solution for Too Big to Fail or preventing financial crises.  Now you can see why.  Unlike transparency, more bank capital dramatically reduces economic growth and it leaves open the possibility of a future bailout/financial crisis.  Talk about a lose/lose proposition.