Researchers at the Federal Reserve Bank of New York on Tuesday released a series of papers on the characteristics and behavior of large and complex banks, which remain a thorny problem for regulators in the wake of the financial crisis. Two of those papers are likely to grab the attention of those who believe the largest banks pose a systemic risk to the economy and ought to be broken up.
The question of whether banks are “too big to fail” has been around for years, but became more salient during the financial crisis, when the federal government bailed out a number of large U.S. banks, in large part out of concern that their failure would have a huge systemic impact on the U.S. economy.
Critics of large banks argue that the perception that the government will intervene to support systemically important banks means that the markets will offer lower lending rates to those banks than they will to smaller institutions, creating unfair competition. In addition, they say that the expectation of a government bailout creates a “moral hazard” – meaning the banks will engage in riskier behavior than they would without a government backstop.
The papers released by the New York Fed on Tuesday lend support to both theories.
One paper, by New York Fed vice president João Santos, examined bond market data and determined that the largest U.S. banks have a significant funding advantage over their smaller competitors.
“Our results show that the spreads of bonds issued by the largest banks are, on average, 40.6 basis points below the smaller banks’ bond spreads, after controlling for bond characteristics, including the credit rating, maturity, and amount of issue, as well as conditions in the bond market at the time of issue.”
Santos allowed for the fact that lenders may simply be more comfortable in the ability of a large bank to repay its obligations, regardless of a government guarantee, so he expanded his analysis to both large non-bank financial institutions and large corporations. He found that in all cases, larger companies enjoyed a funding advantage, but big banks enjoyed a larger advantage over their smaller competitors than either large non-bank financial firms or large corporations.
Santos concludes that “the additional discount that bond investors offer the largest banks, compared to the return they demand from the largest nonbanks and nonfinancial corporations, is novel and consistent with the idea that investors perceive the largest U.S. banks to be too big to fail.”
Another paper, by economist Gara Afonso, Santos, and New York Fed senior research analyst James Traina, examined more than 200 banks from dozens of countries to see whether changes in government support have an impact on the risks banks take.
The authors used the Fitch Ratings agency’s “support rating floors” as a measure of government backing for banks, and determined that as the likelihood of government support for a bank increases, so does the number of risky loans a bank will make. Alarmingly, they also found that the effect was most pronounced on banks that were already seen as riskier than their peers.
“Our findings offer novel evidence that government support does play a role in bank risk-taking incentives,” the authors write. “The results are also important because they already include the effects of the government interventions undertaken throughout the latest financial crisis. At the same time, however, not enough time has elapsed since the crisis for our results to reflect the impact of the regulatory changes enacted in its wake.”
Karen Shaw Petrou, managing partner of Federal Financial Analytics in Washington, DC, says the studies “strengthen the hand” of reformers such as Senate Banking committee member Sherrod Brown (D-OH), who have called for reducing the size of the biggest banks, “since now one key conclusion will, big-bank critics say, have been backed by the Federal Reserve Bank of New York.”
One of those critics, Professor Cornelius Hurley, who directs the Boston University Center for Finance, Law & Policy, said that the finding that big banks get a subsidy is particularly important to the argument against so-called TBTF banks.
“The Big 6 banks are today’s version of Fannie and Freddie but without the pretense of a public mission,” Hurley said. “Since taxing away that subsidy is unlikely, at least these unmanageable, risk-prone banks should be required to put that subsidy away in a separate capital account to protect against the next financial calamity they cause. It’s time for solutions not procrastination as the TBTFs would prefer.”
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