In the years leading up to the financial crisis, market participants assumed that policy makers would intervene to avoid the potential negative economic impact from the failure of a systemically important bank. As William C. Dudley, the president of the Federal Reserve Bank of New York, discussed in a recent speech, the belief that some companies were too big to be allowed to fail gave rise to a variety of problems, notably including a situation of moral hazard that encouraged risky bets by market participants who figured they could keep the upside but have their losses covered by taxpayers.
And indeed, when things went wrong during the crisis, the interventions materialized, as detailed in a recent report by the Government Accountability Office.
The Dodd-Frank financial regulatory reform law of 2010 and regulatory changes since the crisis have affected the incentives for both companies and investors, but it is too soon to say that the advantages and risks of large banks have been addressed or that the era of too big to fail is over. We will not really know until the next time a large bank is on the verge of collapse.
In the meantime, one way to glean information on whether investor perceptions of the potential for future bailouts have changed is to compare the funding costs of large banks relative to small banks.
In an insightful new paper, Randall S. Kroszner of the University of Chicago’s Booth School of Business, a former governor of the Federal Reserve, does just that. Professor Kroszner’s paper was supported by the Clearing House Association, an organization of large banks (I was a member of the association’s now-defunct academic advisory council and a former colleague of Professor Kroszner’s when he served as a member appointed by President George W. Bush at the White House Council of Economic Advisers, but was not involved in the preparation or review of his research).
Professor Kroszner reviews a variety of evidence that suggests that one manifestation of too big to fail before the financial crisis was that large banks could obtain funds with which to make loans and other investments at a lower cost than smaller companies whose demise would not motivate an extraordinary government response.
Not every piece of evidence fits this conclusion – it could be the case, for example, that large companies in every industry have lower costs than smaller ones – and estimates of the magnitude of the pre-crisis funding advantage differ across studies. But the overall conclusion that large banks had a funding advantage suggests an implicit government subsidy from the expectation of government action to support large banks.
Perhaps the best-known effort to quantify this support is the calculation by the editors of Bloomberg View of an $83 billion annual subsidy to the 10 largest United States banks, reflecting a supposed funding advantage of around 0.8 percentage points from the implicit government support multiplied by those companies’ huge liabilities (that is, the money with which they fund their activities).
Small banks tend to rely on deposits for their funding, along with advances from the Federal Home Loan Banks to support mortgage lending; larger institutions rely more heavily on bonds and other capital market sources. There is moral hazard involved with banks of all sizes, because deposits are covered by the Federal Deposit Insurance Corporation, which means that most depositors know that they will not take losses if a bank fails.
But this insurance is explicit and paid for, as opposed to the after-the-fact and unpaid bailout received by bondholders who did not suffer losses because of government interventions.
In a sense, the most unfair bailouts during the crisis were not of banks themselves, but of their bondholders – the investors who provided the funding for the bad lending decisions. Shareholders at Bear Stearns, Fannie Mae, Freddie Mac and the American International Group took sizable losses, but the owners of the bonds of these companies received 100 cents on the dollar as a result of government actions to stabilize the financial system. As I have written elsewhere, these actions were necessary and appropriate, but bailouts nonetheless.
Three important changes made since the financial crisis affect the funding costs of large banks in a way that suggests a reduced government subsidy and a move toward a level playing field with institutions that are not viewed as too big to fail.
The first change is that the resolution authority in Title II of Dodd-Frank gives government officials the power to take over troubled large financial companies and impose losses on bondholders and other funders in a way that was not previously possible. (Until the advent of the Troubled Asset Relief Program, or TARP, the power to stabilize failing companies was limited to the bank subsidiaries of large financial companies but did not encompass other components such as broker-dealers; government officials thus did not have the authority to take over Lehman Brothers, for example.)
Indeed, Title II requires that any losses from a future government intervention must be borne by private market participants, including bondholders.
Investors contemplating the purchase of large bank bonds should understand that they will take losses rather than get a guarantee in the next crisis. This, in turn, should affect funding costs in normal times and reduce the advantage of large banks. It is hard to know if the resolution authority will work as planned (the government agencies involved are still devising the rules), but there is some evidence that the advent of the new law has reduced the perceived likelihood of future bailouts. As Professor Kroszner notes, the three major credit ratings agencies cite the resolution authority as a factor behind their view of a lower likelihood of future government support for large banks.
The second change is that banks must now pay insurance premiums to the F.D.I.C. on their nondeposit sources of funds, even though these borrowings are not covered by the federal guarantee and would take losses under Dodd-Frank Title II. The idea is that deposits tend to be more stable than bonds and other capital market borrowings, so charging banks for using these latter sources of funds provides an incentive against financial system volatility. With large banks the heaviest users of such borrowed money, this effectively moves in the direction of a level playing field with smaller banks.
Finally, the largest banks are required to fund themselves with more capital than smaller banks under the Basel III capital rules and to maintain larger amounts of readily liquid assets. These provisions reflect the desire by policy makers to strengthen the ability of systemically important financial institutions to withstand losses, including in a future financial crisis.
Capital surcharges and heightened liquidity requirements for large banks improve the stability of the financial system, while again moving in the direction of less support for large banks and increased costs relative to smaller ones.
There is evidence that the new regulations are making a difference. An analysis of stock market returns and the cost to insure bank bonds against default indicates that major steps forward in devising financial regulations, such as the Volcker Rule in the United States, resulted in reduced market expectations of future bailouts.
Bond investors, for example, required more compensation to lend to banks as the Dodd-Frank reforms moved forward, with the impact greater for large banks than small banks. In contrast, there was little effect from German financial reforms that were widely seen as ineffective. Bond markets appear to be paying attention to the implications of financial regulatory reform.
It is too soon to say that the changes put in place after the crisis have ended the expectation of government bailouts and the extent to which these changes reduced any implicit support for the activities of large banks.
Still, the situation has changed. The funding advantage of large banks over smaller ones used in the calculation of subsidies by Bloomberg and others is taken from data before the 2010 Dodd-Frank financial regulatory reform and other changes made in the wake of the crisis. Updated analysis would be useful to assess the impact of the post-crisis measures. Professor Kroszner’s paper provides recommendations for future researchers.
Government actions taken during the financial crisis to support large banks were important for stabilizing the financial system and supporting the overall economy. In other words, saving Wall Street was necessary to save Main Street. But the way in which this happened was a source of understandably deep frustration to many Americans (including to the policy makers who undertook the interventions). Reforms made since the crisis have changed the situation.
It is important now to evaluate just how much change has been made. This is a key requirement to know whether more steps are needed.
Phillip Swagel is a professor at the School of Public Policy at the University of Maryland and was assistant secretary for economic policy at the Treasury Department from 2006 to 2009.