In the paper Supersize Them? Large Banks, Taxpayers and the Subsidies that Lay Between, I provide an in-depth study of the substantial, non-transparent governmental subsidies received by the biggest banks. Though some continue to deny the existence of these subsidies, I conclude that the subsidies exist and negatively impact the financial markets. The most significant implicit subsidy stems from market perception that the government will not allow the biggest banks to fail—i.e., that they are “too-big-to-fail” (TBTF)—enabling them to borrow at lower interest rates. I outline the solutions that have been proposed and/or implemented as an attempt to solve the TBTF problem, and I suggest a new user-fees framework that can be used in conjunction with other approaches to mitigate the consequences of the TBTF subsidies.
Posts Tagged ‘Too big to fail’
In a comment letter and supporting paper to the FDIC on its single-point-of-entry (SPOE) resolution concept release, Karen Shaw Petrou, managing partner of Federal Financial Analytics, argues that SPOE is conceptually sound and statutorily robust. However, progress to date on orderly liquidation has been so cautious as to cloud the credibility of assertions that the largest U.S. financial institutions, especially the biggest banks, are no longer too big to fail (“TBTF”). Crafting a new resolution regime is of course a complex undertaking that benefits from as much consensus as possible. However, if definitive action is not quickly taken on a policy construct for single-point-of-entry resolutions resolving high-level questions about its practicality and functionality under stress, markets will revert to TBTF expectations that renew market distortions, place undue competitive pressure on small firms, and stoke systemic risk. Even more dangerous, the FDIC may not be ready when systemic risk strikes again.
Questions addressed in detail in the paper and Ms. Petrou’s answers to them are summarized below:
In the paper, Breaking Bad? Too-Big-To-Fail Banks Not Guilty As Not Charged, forthcoming in the Washington University Law Review, Vol. 91, No. 4, 2014, I focus on the benefits that the largest financial institutions receive because they are too-big-to-fail. Since the 2008 financial crisis, rating agencies, regulators, global organizations, and academics have argued that large banks receive significant competitive advantages because the market still perceives them as likely to be saved in a future financial crisis. The most significant advantage is a government implicit subsidy, which stems from this market perception and enables the largest banks to borrow at lower interest rates. And while government subsidies were the subject of a November 2013 Government Accounting Office report, in the paper I focus on a specific aspect of the benefits the largest banks receive: the economic advantages resulting from exempting the largest financial institutions from criminal statutes. I argue that this exemption—which has been widely discussed in the media over the last few years, following several scandals involving large financial institutions—not only contributes to the subsidies’ economic value, but also creates incentives for unethical and even criminal activity.
Corporate governance incentives at too-big-to-fail financial firms deserve systematic examination. For industrial conglomerates that have grown too large, internal and external corporate structural pressures push to re-size the firm. External activists press it to restructure to raise its stock market value. Inside the firm, boards and managers see that the too-big firm can be more efficient and more profitable if restructured via spin-offs and sales. But for large, too-big-to-fail financial firms (1) if the value captured by being too-big-to-fail lowers the firms’ financing costs enough and (2) if a resized firm or the spun-off entities would lose that funding benefit, then a major constraint on industrial firm over-expansion breaks down for too-big-to-fail finance.
Propositions (1) and (2) have both been true and, consequently, a major retardant to industrial firm over-expansion has been missing in the large financial firm. Debt cost savings from the implicit subsidy can amount to a good fraction of the big firms’ profits. Directors contemplating spin-offs at a too-big-to-fail financial firm accordingly face the problem that the spun-off, smaller firms would lose access to cheaper too-big-to-fail funding. Hence, they will be relatively more reluctant to push for break-up, for spin-offs, or for slowing expansion. They would get a better managed group of financial firms if their restructuring succeeded, but would lose the too-big-to-fail subsidy embedded in any lowered funding costs. Subtly but pervasively, internal corporate counterpressures that resist excessive bulk, size, and growth degrade.
The idea that some banks are “too big to fail” has emerged from the obscurity of regulatory and academic debate into the broader public discourse on finance. Bloomberg News started the most recent public discussion, criticizing the benefit that such banks receive — a benefit that a study released by the International Monetary Fund has shown to be quite large.
Bankers’ lobbyists and representatives dismissed the Bloomberg editorial for citing a single study, and for relying on rating agencies’ rankings for the big banks, which showed that several would have to pay more for their long-term funding if financial markets didn’t expect government support in case of trouble.
In fact, though, there are about ten recent studies, not just one, concerning the benefit that too-big-to-fail banks receive from the government. Nearly every study points in the same direction: a large boost in the too-big-to-fail subsidy during and after the financial crisis, making it cheaper for big banks to borrow.
But a recent research report released by Goldman Sachs argues the contrary — and deserves to be taken more seriously than the first dismissive views. The report concludes that, over time, big banks’ advantage in long-term funding costs relative to smaller banks has been one-third of one percentage point; that this advantage is small; that it narrowed recently (and may be reversing); that it comes from the big banks’ efficiency and their bonds’ liquidity; and that historically it has been mostly small banks, not big ones, that have failed.
The debate regarding “too big to fail” (“TBTF”) has reemerged as a focus of regulators, legislators and the media. We review the regulatory activity since the Dodd-Frank Act was enacted and show that new proposals intended to address TBTF tend to put the policy cart before the regulatory implementation horse.
By our count, regulators have amassed over 1,650 pages in proposed and final rules that seek to address TBTF, which we roughly define as proposals that seek to limit the size of financial institutions, the scope of their activities or otherwise seek to protect the Federal safety net (which we use as a term to refer to any Federal assistance, including deposit insurance). In addition, there are provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“DFA”) which address TBTF that do not require rulemaking.
Despite this volume of regulatory work to implement the DFA’s reforms, which is mostly not yet complete, proposals for new measures are being put forward, including:
A critical policy question is the extent to which “systemic” banks provide value from an economic or social perspective. Much research has been mobilized to demonstrate this, as well as to counter these findings to argue that the biggest banks enjoy undue subsidies because they are so systemic as to be protected by taxpayers. Markets may indeed perceive some big banks as too big to fail (TBTF), but perception does not make reality. Thus, this paper assesses how a systemic financial institution can be differentiated from others to inform the debate over policy responses to TBTF and pending regulatory actions and U.S. legislation to govern the largest financial institutions. Quite simply, if there are no reliable, objective systemic criteria, then policy based on size thresholds or other “systemic” indicators will be at best ineffective antidotes to global financial crises even as they do unnecessary damage to banks and, more broadly, to financial-market efficiency and effectiveness.
In this paper, we assess the ability of regulators to define the criteria that characterize systemically-important financial institutions (SIFIs). The definition of systemic is critical since an array of rules predicated on the negative externalities of SIFIs is under active development. Further, allegations that “systemic” firms, most notably very large bank holding companies (BHCs), are TBTF have aroused calls for additional, generally punitive action for designated institutions.
In a June 3, 2013 closed-door meeting, the Financial Stability Oversight Council (“FSOC”) voted to propose the designation of three financial services companies—American International Group (“AIG”), Prudential Financial and GE Capital—as the first systemically significant nonbank financial institutions (“nonbank SIFIs”) under section 113 of the Dodd-Frank Act.
The FSOC decision, announced by the Treasury Secretary, did not identify specific names, but all three companies publicly confirmed their proposed nonbank SIFI status. If these proposed designations become final, these three companies will become the first nonbank SIFIs to be subjected to stringent Federal Reserve Board oversight and supervision, as well as capital and other regulatory requirements, under Title I of the Dodd-Frank Act. In addition, these designations will bring to life the Dodd-Frank Act’s orderly liquidation authority that applies to systemically significant financial firms, in the event that one of these companies may fail or be in danger of failing in the future.
The FSOC’s action to begin the process of designating nonbank SIFIs has been long awaited—some would say long-overdue—and the identities of the three companies that have been proposed for SIFI designation come as no real surprise. Nonetheless, the FSOC’s action marks an important milestone in the implementation of the Dodd- Frank Act’s systemic regulation framework. While the actual significance of these designations likely will emerge more clearly in the coming weeks and months, the FSOC’s action brings into sharper focus the questions and challenges that the designated firms and their regulators will face.
The report by the US Senate staff on JPMorgan Chase’s “London Whale” trades, delivered last Friday, excoriates the bank for failing to make the full extent of the problem known to regulators and the public. But a focus on who knew what when can result in missing the big point: the cost of our too-big-to-fail banks is even heftier than is widely appreciated.
The conventional wisdom in many circles is that the losses caused by the trades are regrettable but we can all move on. After all, JPMorgan’s equity cushion can readily absorb it. Private shareholders and managers have paid the price – shareholders lost $6bn and several senior managers have black marks against their names. The episode is embarrassing but the bank can earn more than $20bn a year. “A tempest in a teapot,” said Jamie Dimon, its chief executive, last year.
But before the London Whale sinks from view, consider what would befall a conventional industrial company that suffered such a horrendous, expensive managerial lapse. If JPMorgan were in the business of making things, it would have already attracted significant corporate governance activity. The loss might be the trigger for a takeover and break-up effort.
In the first presidential debate, Mitt Romney identified the Dodd-Frank Act as the “biggest kiss” to Wall Street, opening a topic that has received too little attention in this election season. Supporters of the act argue that it ends bailouts, but this is true only if bailouts are defined narrowly as the use of taxpayer funds to rescue a failing financial institution. However, the source of funds for a bailout is not the real issue. The possibility of a creditor bailout creates moral hazard, no matter where the bailout funds originate, and it is moral hazard that provides the largest banks or other large financial firms with competitive advantages. The same is true of the special “stringent” regulation required by the act for banks and other firms deemed systemically important. These provisions create moral hazard by reassuring creditors that there is less risk in lending to these large firms than to small ones, and thus provide the biggest firms with a continuing competitive advantage in the form of lower funding costs. Romney is correct to see this as a subsidy to big banks and other large financial institutions. Title I invokes stringent regulation for systemically important firms, Title II provides a mechanism for bailing out creditors if a systemically important firm should fail, and Title VIII authorizes Federal Reserve funding for an unlimited number of additional financial institutions. If President Obama is re-elected, Dodd-Frank is likely to continue in its current form, adding materially to the problem of moral hazard and TBTF in the US financial system.
At its enactment, the Dodd-Frank Act (DFA) was advertised as legislation that would end financial bailouts. When signing the legislation on July 21, 2010, President Obama said, “There will be no more tax-funded bailouts—period.” But this is an accurate depiction of the act only because the president and the act’s other proponents define bailouts as the use of public funds for rescuing failing financial institutions.