Large banks reacted immediately and angrily to a set of research papers released by the Federal Reserve Bank of New York on Tuesday.
The papers, part of a special edition of the bank’s Economic Policy Review, included one that suggested that big banks have an unfair funding advantage over small banks resulting from investors’ expectation that the government would bail out a large financial institution rather than let it fail and create economic havoc. Another suggested that banks that receive support from the government – such as a perceived willingness to bail them out of trouble – take more risk than banks that have no such guarantee.
Washington-based organizations that represent large financial institutions were quick to challenge the findings of the papers, and lined up academic analysis of their own in support.
John Dearie, executive vice president for policy of the Financial Services Forum, said that bankers were particularly bothered by the paper, written by Federal Reserve Bank of New York vice president João Santos that found a funding advantage for large banks.
He pointed out that Santos’ paper relies on evidence collected prior to 2009, which means it does not include data from after the implementation of the Dodd-Frank Act, which revamped bank regulation. The industry has also implemented other reforms since then, including an overhaul of risk management policies.
Even if a subsidy did exist, he said, “It might well be attributable to perfectly rational, logical expectations on the part of the markets.” He said that large banks tend to have very steady and predictable profits, which could account for bondholders’ willingness to lend to them at a discount.
As to the conclusion that banks that are receiving government support tend to take on more risk than they would otherwise, Dearie said, “Even if you stipulate the conclusion, which we would not, the obvious response to that from a public policy perspective is to subject large banks to enhanced prudential supervision, which is exactly what Title I of Dodd Frank does.”
Other industry representatives, such as The Clearinghouse, and financial services lobbying firms, also disagreed strongly with the studies.
“Banks of different sizes fund themselves in different ways, and broader investigations of funding sources do not necessarily suggest significant differences when correcting for various factors, said the group’s chief economist, Bob Chakravorti. “Furthermore, time periods matters. Some researchers have tried to focus on a more recent period when significant reforms have already been legislated and implemented and find that differences are substantially lower.”
The Clearinghouse earlier this month released a study it had commissioned finding no significant difference in funding costs between large and small banks.
Late Wednesday afternoon, the Federal Reserve Board in Washington delivered some more bad news to a handful of large banks, when it rejected the capital plans of five major banks. The plans, which are reviewed annually, lay out the banks’ methods of measuring and retaining the amount of capital they believe sufficient to protect them against sudden losses.
The Fed rejected the plans of two U.S. banks Citigroup, Zions Bancorp, and three banks with large U.S. operations, HSBC Holdings, Royal Bank of Scotland Group, and Banco Santander. All five will have to revise their plan and resubmit them to the Fed.
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