Left and right, a consensus has formed that "too big to fail" banks are a danger to the real economy and something needs to be done.
The latest solution to gather fans is imposing much higher capital minimums on such banks—a step in the right direction, but no panacea. The problem remains how to discipline their risk-taking even given a bigger capital cushion.
Such banks fund their bets with cheap leverage—cheap because lenders believe their principal is guaranteed by government. At the same time, bank managers are incentivized by the equity markets to exploit every advantage to produce competitive returns to satisfy risk-hungry, well-diversified stock investors. Stiffer capital standards might just prompt them to take concealed risks in ways not understood by regulators.
Higher capital requirements might be a real solution, however, if pushed to their logical conclusion. Let such banks that are "too big to fail" be taxed out of existence by taxing away the value of their implicit government guarantee.
Their complexity and opacity would revert to being what it should be: a reason for investors and lenders to steer clear of them. Let their functions be dispersed to smaller and more focused institutions whose risk-taking can be monitored and disciplined by the capital markets.
Here's guessing that a world without too-big-to-fail banks would not be bereft of financial innovation or diversified services aimed at every kind of customer. It might be a very nice world.The author recognizes that the problem is how to discipline a financial institution when its opacity makes it impossible for capital markets to monitor.
The FDR Framework suggests a solution for this problem. Allow financial institutions to take their choice between holding higher capital requirements or disclosing their current asset and liability-level data.
- Those institutions that opt for disclosing their current asset and liability-level data can now be monitored and disciplined by the capital markets.
- Those institutions that opt for higher capital requirements will have told the capital markets that they are taking on risks that they would prefer to hide. In turn the capital markets can adjust the price and amount of exposure to these institutions to reflect the existence of this risk.