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Borrowing Advantage Of Big Banks Declines Along With Investor Belief In Government Bailout Support

A new study by the Government Accountability Office said that large banks were able to borrow money for less during the financial crisis because investors thought the government would support them, but that the funding advantage "may have declined or reversed."

Posted on July 31, 2014, at 11:38 a.m. ET

Matt Sullivan / Reuters / Reuters

Democratic U.S. Sen. Sherrod Brown, who requested the study.

A long-awaited study by the Government Accountability Office has concluded that the ability of the largest banks to borrow money for less because investors think the government will bail them out if they run into trouble "may have declined or reversed."

The much-anticipated report is part of a long debate swaying in policy and academic circles over whether recent regulatory reforms have been successful in eliminating the expectation that the government will stand behind the largest banks in the case of their failure. Many analysts have pointed to large banks being able to borrow for less before and during the financial crisis as evidence that investors expected them to be bailed out, which would then constitute an implicit taxpayer subsidy reserved for the largest banks.

Those expectations were ratified in 2008 and 2009, when the Treasury and Federal Reserve moved heaven and Earth to rescue the largest banks with hundreds of billions worth of loans, equity investments, and explicit guarantees of some of their debt.

Regulators have "made progress" in writing the rules mandated by the 2010 Dodd-Frank Act, which attempted to set up a system where a large bank could be wound down without threatening the wider economy or requiring taxpayer support, Lawrance Evans, a director at the GAO, plans to say in testimony before the Senate Banking Committee later today. He said that market participants the GAO spoke to "believed that recent regulatory reforms have reduced but not eliminated the likelihood the federal government would prevent the failure of one of the largest bank holding companies."

"The GAO report confirms what we have seen in many recent studies: any cost of funding differential large banks once had has been dramatically reduced if not eliminated," the Financial Services Forum, a bank trade group, said in a statement.

Last year, a Goldman Sachs study concluded that the six largest U.S. banks had a "slight funding advantage" from 1999 until 2007, and that that advantage got significantly larger during the financial crisis. Goldman, however, said that the largest banks had a only a small disadvantage in funding costs from 2011 through early 2013.

The GAO analysis was consistent with that view. Evans said that the GAO's study "suggests that large bank holding companies had lower funding costs than smaller ones during the financial crisis but provides mixed evidence of such advantages in recent years," and that "most models suggest that such advantages may have declined or reversed." The GAO looked at the difference in the yield between bonds issued by banks and equivalently timed bonds issued by the U.S. Treasury, which are considered to be risk-free. The difference between what a treasury yields and what bank debt yields can be seen as the market's perception of the bank's relative riskiness.

The GAO looked at the difference in debt yields between banks with $1 trillion in assets, which would cover Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo, and banks with $10 billion in assets. In 2013, the GAO said that 18 models it used predicted that the larger banks had statistically significant higher funding costs and four models found they had significantly significant lower funding costs. From 2006 to 2009, however, zero models the GAO uses estimated that smaller banks had a funding advantage.

"The report suggests that under more normalized credit conditions, or if there was another crisis tomorrow, investors would flock to the institutions that they believe are Too Big to Fail," Ohio Democratic Sen. Sherrod Brown and Louisiana Republican David Vitter said in a joint statement. "Further, the report confirms that the advantages Wall Street megabanks enjoy today would be roughly the same as they enjoyed back in 2008, suggesting that little progress has been made in addressing Too Big to Fail."

The two senators requested last year that GAO study if large banks receive an implicit subsidy.

The editors of Bloomberg View, the opinion section of Bloomberg News, said that the implicit subsidy to the 10 largest banks amounts to $83 billion a year, and $64 billion flows to the top five largest banks. The editors pointed to research showing that large banks had a 0.8 percentage point funding advantage on all of their debt.

An International Monetary Fund report earlier this year said that the implicit subsidy for the six largest U.S. banks was between $15 billion and $70 billion a year in 2011 and 2012, but that the funding cost advantage had been declining in the U.S. The IMF also said that the subsidy peaked during the financial crisis.

The ratings agency Moody's, which is charged with giving a credit rating to banks' debt, said in a report last year that changes in how large banks can be wound down in the the Dodd-Frank financial regulatory reform bill lead it to lower the rating of some debt of the eight largest banks.

The agency removed the "uplift" — an extra boost in the debt of the holding company for the eight banks — but that the ratings for the debt for the banking units would stay elevated because they assumed it would be supported by the bank holding company.

Whether or not banks receive implicit support from taxpayers, or would in the case of another financial crisis, is a crucial question for lawmaker and regulators considering imposing further, stricter rules on the largest banks. Brown and Vitter are the co-authors of a bill they introduced last year that would greatly increase the capital requirements for banks with over $500 billion in assets.

Under the bill, JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley would have had to increase their capital levels to 15%, well above what international and American regulators mandate. The banks would also have to calculate their capital ratios without adjusting for the riskiness of their assets as current rules allow them to do. Risk weighting, as the adjustment is called, allows banks to have less capital against some of their assets, like debt issued by the U.S. government, while they need more against others, like mortgages or corporate debt.

A bank's capital is money that it uses that isn't borrowed, and the more borrowing a bank does, the more earnings it can generate for its shareholders (and the more at risk it is for going under thanks to a loss).

A big hike in capital requirements — which have already gone up considerably since the financial crisis — would dent banks profitability as they would be less able to juice up their profits with borrowed money. At the same time, however, such a move could also make them more stable. The study was part of Brown and Vitter's strategy to show that a portion of the profits banks generate now is thanks to an implicit subsidy from the public. But that claim is now in doubt.

Even if banks still receive an implicit subsidy, or would in a crisis, the largest banks have also born the brunt of regulations specifically targeted at them in order to make them more stable. In April, bank regulators in the U.S. proposed a rule requiring stiffer restrictions on bank borrowing for banks with more than $700 billion in assets.

The largest and most complex banks also have to comply with more rules that cover the diversity of their activity and some, like JPMorgan Chase, have hired thousands of employees to deal with new regulations. JPMorgan's chief financial officer said in an investor presentation in February that the bank would spend an extra $2 billion in 2014 on compliance and controls.

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