The "Too Big To Fail" Subsidy

David Dayen @ American Prospect:

Financial reformers in both parties have insisted for years that the largest banks remain too big to fail, and that Dodd-Frank did not cleanse the system of this reality. You can mark down this week as the moment that this morphed into conventional wisdom. In successive reports, two of the more small-c conservative economic institutions, without any history of agitating for financial reform—the Federal Reserve and the International Monetary Fund—both agreed that mega-banks, in America and abroad, enjoy a lower cost of borrowing than their competitors, based on the perception that governments will bail them out if they run into trouble. This advantage effectively works as a government subsidy for the largest banks, allowing them to take additional risks and threaten another economic meltdown. With institutional players like the Fed and the IMF both identifying the same problem, Wall Street grows more and more isolated, setting up the possibility of true reform.

The idea that big banks can borrow more cheaply makes intuitive sense. Say you’re an investor with the option of lending money to a big bank or a smaller one. If you know that, in the event of catastrophe, the smaller institution will get swallowed up by the FDIC without an investor payoff, while the big bank will get protected with a taxpayer bailout, of course you would feel that your money is safer with the big bank. Therefore, investors ask for higher interest rates from smaller banks, because of the greater risk of losses. This also distorts market discipline, as investors have no reason to worry about excessive risk-taking at a too-big-to-fail bank if the government will clean up the mess regardless. Even if the government insists that the era of bailouts has ended, the mere perception by investors about the safety of their funds in a too-big-to-fail bank drives borrowing costs lower.

Federal Reserve research, put out last week as part of the annual Economic Policy Review, makes the historical case for this disparity. Using a twenty-four year dataset, João Santos of the Federal Reserve Bank of New York argues that the largest banks have a cost advantage “consistent with the hypothesis that investors believe the banks are ‘too big to fail.’” Santos compared bonds of similar characteristics issued by banks of all sizes, and calculated that larger banks, on average, raise money at interest rates between 0.31 and 0.41 percent lower than their smaller counterparts.

This sounds small, but when you consider the hundreds of billions in that the average mega-bank borrows in a typical year, the amounts can add up. If you multiply that figure by the total liabilities of the top ten U.S. banks, it equals as much as $45 billion a year in subsidy, around half of the mega-banks’ annual profits (previous data put the subsidy at almost twice as much). Santos broadened the investigation by looking at the firms outside the banking sector, and found that their borrowing advantage relative to smaller competitors does not hold when comparing similar types of bonds. “These results suggest that the cost advantage… is unique to banks,” Santos writes.

The problem is that the dataset goes from 1985 to 2009, ending before passage of Dodd-Frank and its implementation. Therefore, this data alone, while confirming the existence of a consistent borrowing advantage for big banks over time, cannot answer whether Dodd-Frank fixed the problem and eliminated the subsidy. However, additional Fed research, using data through 2013, showed that the largest banks take bigger risks than their peers, suggesting that they still rely on the likelihood of government aid if they fall into crisis.

The IMF report looked at banks all over the world, and just to make things more confusing, they used the term “too important to fail” rather than the more common idiom. But they arrived at much the same conclusion as the Federal Reserve, even when analyzing data from after 2009. In fact, because we have a test case for whether governments will seek bailouts—the massive support handed to banks in the wake of the 2008 financial crisis—the IMF believes that the problem “has likely intensified.” Banks have grown more concentrated since 2008, and as the IMF notes, they did so by responding to the major incentives to grow: the bailout protection and the borrowing subsidy…