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From Banking and Finance Law Daily, March 26, 2014

Megabanks take more risks, get better funding, New York Fed studies conclude

By J. Preston Carter, J.D., LL.M.

Research papers on large and complex banks written by economists at the Federal Reserve Bank of New York conclude that those banks engage in riskier activities and enjoy a large funding advantage than smaller banks, but that limiting their size might increase the cost of providing banking services. These findings are presented in the first releases in a series of Liberty Street Economics blog posts and Economic Policy Review papers on large and complex banks to be published over a two-week period.

“We believe that good research is a vital input to sound economic policy,” said Jamie McAndrews, Executive Vice President and head of the New York Fed’s Research and Statistics Group. “This is nowhere more true than in the policy issues surrounding the public debate on large and complex banks.”

Key findings. Among the papers’ key findings are that:

  • Bank size has benefits and costs: the upside is the potential for economies of scale and lower operating costs; the downside is the “too-big-to-fail” problem and associated funding advantages and moral hazard;

  • Banks have become less bank-centric and more organizationally complex. Furthermore, the increase in bank complexity may be a natural response to an evolving intermediation technology; and

  • Bail-in regimes, where the claims of creditors of the parent company are converted to equity in resolution, are an efficient and superior process for resolving the failure of a large financial firm. Requiring systemically important bank holding companies to issue “bail-inable” long-term debt that converts to equity in resolution would make large bank failures more orderly.

Large bank risk level. “Too-Big-to-Fail” banks engage in riskier activities by taking advantage of the likelihood that they’ll receive government aid, according to research findings published in a Liberty Street Economics blog post titled “Do ‘Too-Big-to Fail’ Banks Take On More Risk?” In order to measure government support, the authors relied on Fitch’s Support Rating Floors. This rating isolates the likelihood of government support from other forms of support, such as from parent companies or institutional investors. The SRFs are based solely on Fitch’s opinion of potential government support, that is, the will and ability of a government to support a bank.

The authors compiled bank-level data for 224 banks in 45 countries that includes Fitch ratings and balance-sheet information from March 2007 to August 2013. They measured the riskiness of a bank’s lending business by the ratio of impaired loans to total assets. Impaired loans are loans that are either in or close to default and are typically considered a good measure of the amount of bad debt in a bank’s loan portfolio.

The authors looked at the effect on a bank’s impaired loans one to eight quarters after a change in its SRF, and they discovered that stronger government support translates into a higher ratio of impaired loans. Importantly, they said, this effect steadily increases through time and persists even eight quarters after a change in support.

Finally, they found similar results when they looked at the effect of changes in government support on net charge-offs, a related measure of bad debt in bank loan portfolios. Moreover, they discovered that this effect was still present when they zoomed in on U.S. banks only. An expanded version of the authors’ study is presented in an Economic Policy Review paper.

Large bank cost advantage. A study of domestic bond issues from 1985-2009 concludes that the largest banks benefit from a larger funding advantage than do the largest nonbank financial institutions as well as the largest nonfinancial corporations, according to a Liberty Economics blog post titled “Evidence from the Bond Market on Banks’ ‘Too-Big-to-Fail’ Subsidy.” The author says this suggests that investors view the largest banks as being more likely to be rescued if they get into financial difficulties. However, the author noted, since the sample he used ends in 2009, the findings do not reflect any changes in bond investors’ expectations resulting from some of the interventions that occurred during the financial crisis or from the passage of the Dodd-Frank Act in 2010.

The author discovered that the largest banks benefit from a larger cost advantage (relative to their smaller peers) when compared to the similar cost advantage that the largest firms in other sectors of activity may also enjoy when they raise funding in the bond market. He found that the largest five banks pay on average 406 basis points below the smaller banks’ bond spreads, after controlling for bond characteristics, including the credit rating, maturity and amount of issue, and the overall conditions in the economy at the time of issue.

The research also shows that the largest banks that issue bonds rated double-A and single-A benefit from a discount (relative to their smaller peers) that is larger by 92 and 16 basis points, respectively, than the discount that the largest nonbank financials that issue bonds with those same ratings enjoy (relative to their smaller peers), though the difference is only statistically significant in the former case. When compared to the largest nonfinancial corporations, the largest banks that issue bonds rated double-A and single-A benefit from an additional discount of 53 and 50 basis points, respectively, though only the latter difference is statistically significant. An expanded version of the author’s study is presented in an Economic Policy Review paper.

Large bank lower operating costs. Limits on bank holding company size may, due to undercutting economies of scale associated with large banks, increase the cost of providing banking services, according to a Liberty Street Economics blog post titled “Do Big Banks Have Lower Operating Costs?” The authors cautioned, however, that this drawback must be weighed against the potential financial stability benefits of limiting firm size.

The authors pointed to recent studies implying that the introduction of limits on bank size would impose “deadweight economic costs” by increasing the cost of providing banking services. To further this research, the authors studied the relationship between size and components of noninterest expense, which information they garnered from banks quarterly regulatory FR Y-9C filings.

Their findings implied that for a BHC of mean size, an additional $1 billion in assets reduces noninterest expense by $1 million to $2 million per year, relative to a base case in which operating cost ratios are unrelated to size. Those results were the same across the size distribution of banking firms. According to the authors, their paper suggests that limiting BHC size to be no larger than 4 percent of GDP would increase total noninterest expense by $2 to $4 billion per quarter. An expanded version of their findings are presented in an Economic Policy Review paper.

Brown and Vitter response. Responding to the studies, Sens. Sherrod Brown (D-Ohio) and David Vitter (R-La), sponsors of the Terminating Bailouts for Taxpayer Fairness Act (see Banking and Finance Law Daily, April 24, 2013), stated that “[T]he New York Fed confirmed what regulators and thought leaders of diverse ideologies have been saying: that Wall Street megabanks get advantages due to their ‘Too Big to Fail’ status.”

The Senators said they have successfully pressed the Government Accountability Office to conduct a study of the economic benefits that the “too-big-to-fail” megabanks receive as a result of actual or perceived taxpayer funded support. They also stated that their bill would ensure that financial institutions have adequate capital to protect against losses.

MainStory: TopStory BankHolding BankingOperations DoddFrankAct FinancialStability

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