How can we manage banks that may be too big to fail?

Question: How much higher should the capital ratios of big banks be relative to small banks? (Felix Salmon, Reuters Finance)

John Allison: I don’t think the capital ratios of big banks should be higher than small banks. In fact, my experience is exactly the opposite, the small banks are the ones that tend to be the most under capitalized and particularly start-up small banks. But I think everybody’s capital ratios ought to be higher. I think that government policy has encouraged banks to have lower capital than they should. One of my cures, long term, for the industry, it’s not my optimal cure, but it’s a more practical cure, would be to set a goal for banks to have 20, 25% equity, give them a long term time to do that and shift the risk from the taxpayers back to the shareholders of the bank. It would also answer the two big, the failed question in that either Citicorp could raise that kind of capital or not, and if they couldn’t, then they would have to shrink. Now, it’s very important that be combined with several things. One, we need to reduce the FDIC insurance back to the $100,000 level to take out that risk. Secondly, we need to make it explicitly clear the Federal Reserve can’t bail out General Electric or non-banks because banks have to have a special proxy if they have to have a higher capital levels and it should be against the last for General Electric to be bailed out by the Federal Reserve.

And finally, you have to eliminate about 90 or 95 percent of the regulations that impact the industry because the industry can’t afford to have higher capital levels and a huge regulatory burden. So we ought to shift the risks back to shareholders, 20-25% of pure capital for all banks in a long-term systematic fashion, but coordinated with substantiated reduced regulation, so the industry can be competitive and healthy.

Question: Should money center banks be broken up? (Robert Lenzer, Forbes)

John Allison: Well, my general posture is that I am opposed to any trust. On the other hand, if the government has determined some institutions are too big to fail, then they have to be broken up because it creates huge market distortions, particularly in the good times. Because anybody that has an implicit government guarantee can afford to take dramatically more risk. So what’s going to happen, if we don’t break up the institutions that are too big to fail, then on the next cycle, when the good times comes, they’ll come, they’ll be taking enormous risk and then the next cycle will be a really, a disaster. I personally don’t believe they’re too big to fail. I think they should be allowed to fail and there ought to be a process where they fail just like any other company and then you wouldn’t have to break them up. The capital requirement that I described in the last, answer to the last question, really would help deal very effectively with this issue.