Fed Economist Says Big Bank Borrowing Advantage Increases Risk

Photographer: Peter Foley/Bloomberg

The five largest banks by assets are JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and Goldman Sachs Group Inc. Close

The five largest banks by assets are JPMorgan Chase & Co., Bank of America Corp.,... Read More

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Photographer: Peter Foley/Bloomberg

The five largest banks by assets are JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and Goldman Sachs Group Inc.

The largest U.S. banks, including JPMorgan Chase (JPM) & Co. and Citigroup Inc., have been able to borrow more cheaply in bond markets than smaller rivals, in part because of investor perceptions that they were too big to fail, according to a Federal Reserve Bank of New York researcher.

The five largest banks paid on average 0.31 percentage point less on A rated debt than their smaller peers, according to a paper released today by the Fed district bank based on data from 1985 until 2009.

“This insensitivity of financing costs to risk will encourage too-big-to-fail banks to take on greater risk,” Joao Santos, a vice president at the Fed bank, wrote in his paper. This “will drive the smaller banks that compete with them to also take on additional risk.”

The study may reinforce efforts by lawmakers to eradicate the implicit federal subsidy by either breaking up the biggest banks or increasing capital requirements. Large banks have said their advantage has been overstated in studies, including a May 2012 report by the International Monetary Fund estimating their borrowing edge at 0.8 percentage point.

Santos’s report is one of 11 studies resulting from a year-long research project on the U.S. banking system involving about 20 New York Fed staff economists. Fed district banks in Dallas, Minneapolis and Richmond have also published research on too-big-to-fail, or the perception that large banks will be rescued by the government if they get into trouble.

Bigger Discount

The study also found that the largest banks enjoyed a funding-cost advantage over large non-bank financial firms as well as the biggest non-financial corporations.

This finding suggests that “investors believe the largest banks are more likely to be rescued if they get into financial difficulty,” according to Santos.

The five largest banks by assets are JPMorgan Chase, Bank of America Corp., Citigroup, Wells Fargo & Co. and Goldman Sachs Group Inc.

Some lawmakers are seeking to limit size by penalizing the largest lenders. Senator Sherrod Brown, a Democrat from Ohio, along with David Vitter, a Republican from Louisiana, introduced a bill last year that would impose a 15 percent capital requirement on banks with more than $500 billion in assets. Prior efforts by Brown have not succeeded.

“It’s time to level the playing field for all financial institutions and prevent taxpayers from being on the hook for risky megabank practices,” Brown said today in a release.

The Financial Services Forum, which represents the chief executive officers of the 18 largest banks, said the report fails to account for the period since the passage of the 2010 Dodd-Frank Act, which was intended to ensure that a big bank’s failure won’t pose a risk to the financial system.

‘Significant Improvements’

“The fact that it is old data before the crisis and does not include all of these pretty significant improvements to the financial sector will allow some to discount some of it,” said Rob Nichols, the group’s president and CEO.

Senator Elizabeth Warren, a Democrat from Massachusetts, has introduced a bill aimed at re-creating the Glass-Steagall Act, the Depression-era measure that separated commercial and investment banking. Her bill is cosponsored by Senator John McCain, a Republican from Arizona.

The perception the banks are too big to fail may not be the only reason the big banks can borrow more cheaply, Santos said.

“To the extent that the largest banks are better positioned to diversify risk because they offer more products and operate across more businesses (something not fully captured in their credit rating), this wedge could explain part of that difference in the cost of bond financing,” he said.

Typographical Error

The paper initially put the funding advantage of the largest banks at 408 basis points. That figure was later changed to 40.6 basis points because it was found to be a typographical error, according to Andrea Priest, a New York Fed spokeswoman.

The corrected figure represents the average funding advantage of larger banks over their smaller rivals, after adjusting for differences in credit rating, maturity and amount of issue, as well as conditions in the bond market at the time, she said. Fed officials said at the press conference that 31 basis points might be a better measure because most bonds fall into the A rated category.

Regulatory Changes

The New York Fed report says its findings are “pertinent to the ongoing debate on requiring bank-holding companies to raise part of their funding with long-term bonds, particularly if the regulatory changes that were introduced are unable to fully address the too-big-to-fail status of the largest banks.”

Changing the organizational structure of big banks or reducing their size may not result in the best outcomes for consumers or markets, a New York Fed economist said at a briefing today. Limiting the size of bank-holding companies to 4 percent of gross domestic product, for example, could raise non-interest expenses for the industry by $2 billion to $4 billion, the economist said.

Fed Chair Janet Yellen said last month it may be premature to say regulators have eliminated the too-big-to-fail challenge.

“I’m not positive that we can declare, with confidence, that too-big-to-fail has ended until it’s tested in some way,” she testified to the Senate Banking Committee on Feb. 27.

Lawmakers aim to reduce the odds the government will use taxpayer funds to bail out lenders. During the financial crisis, the government provided billions in bailouts to banks. The central bank used its balance sheet to rescue brokerage firm Bear Stearns Cos. and insurer American International Group Inc. and to support other non-bank institutions through emergency lending programs.

Government Backstops

The government’s precedent-setting backstops against financial risk means that the proportion of total U.S. financial firms’ liabilities covered by the federal financial safety net has grown 27 percent during the past 12 years, according to Richmond Fed economists.

The -Frank Act, the most sweeping rewrite of financial rules since the 1930s, set out to end too-big-to-fail and gave the Fed enhanced powers to set new standards for capital, liquidity and risk management on the largest banks and financial institutions deemed systemically risky by a council of regulators.

Fed officials are considering an array of new rules and standards for large banks. These range from a set of capital surcharges making it more costly for banks to grow larger, to a rule that would force banks to maintain minimum amounts of holding company debt convertible into equity in a failure.

Fed officials have also pledged greater scrutiny on mergers by large banks, while urging banks to increase capital buffers through annual stress tests that pose catastrophic economic scenarios. Banks can fail on both qualitative and quantitative grounds, prompting regulators to oppose capital payouts through dividend increases or stock buybacks.

To contact the reporters on this story: Cheyenne Hopkins in Washington at chopkins19@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net

To contact the editors responsible for this story: Maura Reynolds at mreynolds34@bloomberg.net James L Tyson, Chris Wellisz

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