Goldman Sachs Research Disputes ‘Too Big to Fail’ Subsidy

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Bond investors don’t perceive the six biggest U.S. banks as “too big to fail,” according to a report from one of those lenders, Goldman Sachs Group Inc.

The half-dozen largest U.S. banks by assets have had an average funding-cost advantage over smaller competitors of 0.31 percentage point since 1999, according to the report from the New York-based firm. The advantage was widest in the financial crisis and then reversed so that the biggest banks now pay an average 0.10 percentage point more than smaller ones, the study found.

Some policy makers have said the biggest U.S. banks -- JPMorgan Chase & Co. (JPM) (JPM), Bank of America Corp. (BAC), Citigroup Inc. (C) (C), Wells Fargo & Co. (WFC) (WFC), Goldman Sachs and Morgan Stanley -- benefit from cheaper borrowing costs because bond investors assume the government will bail them out in a financial crisis, as happened in 2008. Lobbyists for the lenders have pushed back against proposals that aim to counteract that funding advantage.

“We find that the largest firms in nearly all industries do indeed benefit from lower bond-funding costs than their smaller peers, and that the biggest banks actually benefit less,” according to the report. “This undermines the notion that government support drives a TBTF funding advantage.”

The report analyzed bond spreads for the six biggest U.S. banks and all others whose debt is included in the iBoxx investment-grade debt index, a listing created by Markit Group Ltd., which is partly owned by Goldman Sachs.

Liquidity Gap

Big banks depend more on bond-market funding than small lenders, which use deposits to fund their loans. The report asserts that the banks that sell more debt are more attractive to investors because the size of the bond issues makes them easier to trade.

“Investors are willing to pay for the benefits of liquidity, and large firms tend to have more liquid bonds,” according to the report. “In fact, the added liquidity itself could account for the observed funding advantage for the largest banks.”

The report cites data from Trace, the bond-price reporting system of the Financial Industry Regulatory Authority, showing that the bonds of banks with more than $500 billion in assets trade “virtually every day,” while those issued by the smallest lenders in the market change hands just once a week.

“It would take close to three months for markets to trade just $50 million of a typical small bond-issuing bank’s debt,” according to the report. “For one of the largest banks, this could be accomplished in less than two hours.”

Counter Report

In a counter report, the Independent Community Bankers of America said that of 15 studies it reviewed all except one by JPMorgan found a “significant” too-big-to-fail subsidy. The resulting cost savings enjoyed by the 10 largest banks has more or less equaled or exceeded their net income, the community bank trade group said.

“The persistence of lower funding costs for the megabanks despite their riskier activities indicates that markets are disregarding resolution authority and continue to price in a government backstop,” ICBA said in its report.

The ICBA used its report to endorse a bill by Senators Sherrod Brown, a Democrat from Ohio, and David Vitter, a Republican from Louisiana, that would set a 15 percent capital requirement for so-called megabanks, those over $500 billion in assets, as a way to reduce risk and remove the perception that they would get bailouts in a crisis.

At least six banks have assets exceeding the $500 billion capital standard: JPMorgan, Citigroup, Goldman Sachs and Morgan Stanley (MS), all based in New York, as well as Charlotte, North Carolina-based Bank of America and San Francisco-based Wells Fargo.

Declining Benefits

Policy makers in the U.S. and around the world have been devising strategies to eliminate or offset the too-big-to-fail funding advantages found in some studies. Credit-rating companies also assign higher ratings to the bonds of the biggest banks, upgrades that have been based on an expectation that they would be rescued by the government in the event of a crisis.

“Over time you’ll see increasing market expectations that these institutions can fail,” Federal Reserve Chairman Ben S. Bernanke told the Senate Banking Committee in February. “The benefits of being large are going to decline over time, which means some banks are going to voluntarily begin to reduce their size.”

Simon Johnson, an economics professor at the Massachusetts Institute of Technology and a Bloomberg View columnist, said that Goldman Sachs’s report proves the value of the too-big-to-fail subsidy because it shows the biggest banks enjoyed a large advantage during the financial crisis.

Skewed Findings

“When is it valuable for me to be too big to fail?” Johnson said. “When it’s really valuable is when there’s stress in the system.”

Comparing funding costs of big, international, complex banks and smaller lenders fails to account for differences in their business models and leverage, he said.

“The question is whether the big financial conglomerates borrow more cheaply than they would otherwise,” Johnson said. “Because if you’re comparing them with small banks, there’s a lot of other things going on there.”

The Goldman Sachs report said that prior studies estimating the funding advantage enjoyed by the largest lenders have been skewed because they included non-bank financial institutions, which enjoy a higher funding advantage, and also included firms outside the U.S.

The Goldman Sachs report was prepared by the firm’s public policy research unit, called the Global Markets Institute. A disclosure on the report said that it may have been discussed with or reviewed by people outside the research division, both within and outside Goldman Sachs, while it was being prepared.

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net

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