Fed Finds TBTF Banks Increase Systemic Risk, Have A Funding Advantage

Tyler Durden's picture

For some inane reason, about a year ago, there was a brief - and painfully boring - academic tussle between one group of clueless economists and another group of clueless economists, debating whether Too Big To Fail banks enjoy an implicit or explicit taxpayer subsidy, courtesy of their systematic importance (because apparently the fact that these banks only exist because they are too big in the first place must have been lost on both sets of clueless economists). Naturally, it goes without saying that the Fed, which as even Fisher now admits, has over the past five years, worked solely for the benefit of its banker owners and a few good billionaires, has done everything in its power to subsidize banks as much as possible, which is why this debate was so ridiculous it merited precisely zero electronic ink from anyone who is not a clueless economist. Today, the debate, for what it's worth, is finally over, when yet another set of clueless economists, those of the NY Fed itself, say clearly and on the record, that TBTF banks indeed do get a subsidy. To wit: " in fact, the very largest (top-five) nonbank firms also enjoy a funding advantage, but for very large banks it’s significantly larger, suggesting there’s a TBTF funding advantage that’s unique to mega-banks."

Hopefully this will put this absolutely meaningless and most obtuse "debate" in the dustbin of time-wasting economic discourse, which is virtually all of it, where it belongs.

For those who care, here is some more drivel from the NY Fed:

Until recently, having mega-banks seemed like an unmitigated bad; they create systemic risk and there was little convincing evidence of economies of scale beyond a relatively small size. However, just in the last five years several papers have found scale benefits even for trillion-dollar banks. The first paper in the volume, “Do Big Banks Have Lower Operating Costs?” by Anna Kovner, James Vickery, and Lily Zhou, contributes to that recent literature by showing that bank holding company (BHC) expense ratios (noninterest expense/revenue) are declining in bank size. In a back-of-the-envelope calculation, the authors estimate that limiting BHC assets to 4 percent of GDP, as has been advocated, would increase noninterest expense for the industry by $2 billion to $4 billion per quarter. Breaking up mega-banks is not a free lunch.


The other edge of the sword, of course, is the potential funding advantages and moral hazard associated with being perceived as too big and complex to fail (TBTF). A paper by João Santos, “Evidence from the Bond Market on Banks’ ‘Too-Big-to-Fail’ Subsidy,” adds to the growing literature that tries to quantify the TBTF funding advantage, but Santos adds a twist; he tests whether all very large firms, including nonfinancial firms, enjoy a funding advantage. He finds that, in fact, the very largest (top-five) nonbank firms also enjoy a funding advantage, but for very large banks it’s significantly larger, suggesting there’s a TBTF funding advantage that’s unique to mega-banks.


Along with a funding advantage, being perceived as TBTF may create moral hazard. While it’s almost universally presumed that TBTF banks take excessive risk, recent research challenges that presumption; if the TBTF subsidy increases mega-banks’ franchise value, they may play it safe to conserve that value. In “Do ‘Too-Big-to-Fail’ Banks Take On More Risk?” Gara Afonso, João Santos, and James Traina test the moral hazard hypothesis using Fitch’s government support ratings as a proxy for TBTF status (a support rating reflects a rating agency’s views on the likelihood of government assistance for a systemically important bank). They find that a one-notch increase in support ratings is associated with an 8 percent (relative to average) increase in the impaired loan ratio, consistent with the traditional moral hazard story.


The takeaway from these three papers is that bank size has benefits and costs: The upside is the potential for economies of scale and lower operating costs; the downside is the TBTF problem and the attendant funding advantages and moral hazard.

And Bloomberg's take, which as a reminder was one of the very "serious" news organization that - correctly - accused the Fed of providing banks with tens of billions in implicit funding subsidies. What other media outlets, or anyone who defended the opposite view, were thinking is simply beyond comprehension.

The largest U.S. banks, including JPMorgan Chase & Co. and Citigroup Inc., can borrow more cheaply in bond markets than smaller rivals, in part because of investor perceptions that they are too big to fail, according to a Federal Reserve Bank of New York researcher. The five largest banks pay on average 0.31 percentage point less on A-rated debt than their smaller peers, according to a paper released today by the Fed district bank based on data from 1985 until 2009.


“This insensitivity of financing costs to risk will encourage too-big-to-fail banks to take on greater risk,” Joao Santos, a vice president at the Fed bank, wrote in his paper. This “will drive the smaller banks that compete with them to also take on additional risk.


The study may reinforce efforts by lawmakers to eradicate the implicit federal subsidy by either breaking up the biggest banks or increasing capital requirements. Large banks have said their advantage has been overstated in studies, including a May 2012 report by the International Monetary Fund estimating their borrowing edge at 0.8 percentage point.


Santos’s report is one of 11 studies resulting from a year-long research project on the U.S. banking system involving about 20 New York Fed staff economists. Fed district banks in Dallas, Minneapolis and Richmond have also published research on too-big-to-fail, or the perception that large banks will be rescued by the government if they get into trouble.


The study also found that the largest banks enjoy a funding-cost advantage over large non-bank financial firms as well as the biggest non-financial corporations.


This finding suggests that “investors believe the largest banks are more likely to be rescued if they get into financial difficulty,” according to Santos. The five largest banks by assets are JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and Goldman Sachs Group Inc.


The perception the banks are too big to fail may not be the only reason the big banks can borrow more cheaply, Santos said. “To the extent that the largest banks are better positioned to diversify risk because they offer more products and operate across more businesses (something not fully captured in their credit rating), this wedge could explain part of that difference in the cost of bond financing,” he said.


The New York Fed report says its findings are “pertinent to the ongoing debate on requiring bank-holding companies to raise part of their funding with long-term bonds, particularly if the regulatory changes that were introduced are unable to fully address the too-big-to-fail status of the largest banks.”

Even that wise sage of monetary policy, the Mr.Chairmanwoman, chimed in. Wrongly of course.

Fed Chair Janet Yellen said last month it may be premature to say regulators have eliminated the too-big-to-fail challenge.


“I’m not positive that we can declare, with confidence, that too-big-to-fail has ended until it’s tested in some way,” she testified to the Senate Banking Committee on Feb. 27.

Wait someone said it ended?  As for testing it, how about sending the market plunging by 1% or more? Surely with leverage being where it is, that should be sufficient for the Fed to need to bail out at least a few hundred of America's most insolvent banks.

Finally, for those who missed it, the sheer idiocy of the Fed spending millions in taxpayer funds to "find" whether TBTF banks are getting implicit taxpayer funds is something only economists are capable of.

The NY Fed's "research" paper on the topic can be found here, while the NY Fed's blog on this topic is here.