Fed’s Kashkari says higher capital requirements would strengthen banking system

After the resounding failures of Silicon Valley Bank and Signature Bank, Minneapolis Federal Reserve Chairman Neel Kashkari argued that requiring banks to have higher levels of capital could be the best solution to remedy the underlying weakness of the banking system.

“[It’s] our only chance to build real resilience in our financial system,” he said in an essay posted this morning on the Minneapolis Fed website.

Kashkari referred to the three massive government interventions over the past 15 years: the 2008 financial crisis, the response to the COVID-19 pandemic, and the collapse of banks, including most recently the First Republic.

“Can’t we do better as a nation? he wrote.

As regulators consider making changes to toughen the system, he cautioned against the same attempts at previous fixes, such as hiring more staff and developing smarter stress tests.

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

Although it is difficult to predict the next shock, he suggested that sufficient capital can protect against almost any scenario.

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

He said during an appearance on CNBC This Morning that he had yet to see evidence of stress in the banking industry affecting his region, which includes Minnesota. But he said it remains to be seen whether that has an impact on inflation.

Kashkari has a vote this year on the Fed’s rate-setting committee. He said he was open to pausing interest rate hikes next month, but added that would not mean the Fed is done raising rates.

In his essay, he noted that a number of analyzes have concluded that capital levels in the banking sector, although 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 capital, their depositors would have been reassured because the banks could have absorbed their mark-to-market losses,” he writes. “Higher levels of capital can both address the too-big-to-fail advantage of larger banks (which surprisingly tend to have much lower levels of capital than smaller banks) and can reduce the complexity of our regulatory apparatus.

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

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