U.S. Banks Enjoy 'Too-Big-To-Fail' Advantage: Fed Study

A landmark study by Federal Reserve economists found that large U.S. banks enjoy a "too-big-to-fail" advantage in financial markets, confirming the suspicions of many Wall Street critics more than five years after the financial crisis.

The series of research papers, published on Tuesday by the U.S. central bank's influential New York branch, suggests the biggest and most complex banks benefited even after the financial crisis from lower funding and operating costs compared to smaller firms. The researchers used data through 2009.

The biggest banks also, Fed economists found, can take bigger risks than their smaller peers.

While the study did not pinpoint the reason big banks borrow more cheaply, Wall Street critics say it is because investors believe the U.S. government would again rescue them in a panic, despite new rules adopted in the wake of the 2007-2009 crisis and aimed at avoiding future bailouts.

"The evidence presented in this paper on the additional discount that bond investors offer the largest banks ... is novel and consistent with the idea that investors perceive the largest U.S. banks to be too big to fail," Joao Santos, a vice president at the New York Fed, wrote in a paper on fund-raising by banks, insurance companies and corporations.

Fed economists estimated the funding advantage for the five largest banks over smaller peers to be about 0.31 percent, which they said was statistically significant. The Fed said the papers represented the conclusions of their individual authors, not the central bank itself.

Banks and Wall Street critics have been at loggerheads for years over whether enough has been done to prevent regulators from bailing out banks in a future crisis. The study could influence regulators as they decide how strict forthcoming rules related to the 2010 Dodd-Frank financial reform law will be.

The financial services industry, eager to avoid more regulation, has argued that Dodd-Frank did its job.

The Clearing House, an industry group for the biggest banks, published a study last week that found the difference in funding costs between large and small firms was negligible.

But Democratic Senators Elizabeth Warren of Massachusetts and Sherrod Brown of Ohio and other skeptics in Congress repeatedly warn that the nation's biggest banks, such as Bank of America Corp <BAC.N> and JPMorgan Chase & Co <JPM.N>, are still viewed as too integral to the U.S. economy to fail.

Brown called The Clearing House study an attempt by banks to "protect the status-quo that requires hardworking taxpayers to pay for their risky activities."

The 11 papers published on Tuesday represent an effort by the Fed to join a conversation that still dominates Washington. The New York branch conducts the Fed's trading in financial markets and is its frontline in supervising Wall Street.

SOLUTIONS

Fed staff wrote in one paper that a greater likelihood of government support leads to more risk-taking at big banks, including impaired lending and net charge-offs.

But in another, they cautioned that the solution may not be to impose limits on the size of banks. That could disrupt economies of scale that keep the cost of banking services low for most Americans, they said.

They noted that limiting bank holding companies' assets to no more than 4 percent of U.S. gross domestic product, as some have suggested, would increase industry-wide non-interest expenses by $2 billion to $4 billion each quarter.

"Limiting the size of banking firms could still be an appropriate policy goal, but only if the benefits of doing so exceeded the attendant reductions in scale efficiencies," researchers and economists Anna Kovner, James Vickery and Lily Zhou wrote.

Regulators have shied away from suggestions that they should break up banks, pointing instead to the new rules that require banks to reduce leverage, maintain a supply of assets they could sell quickly, and stop making risky trades with their own money.

Officials say they also have made strides to ensure regulators are equipped to resolve big banks in a crisis rather than bail them out.

The Dodd-Frank law assigned new powers to the Federal Deposit Insurance Corp (FDIC) to allow it to take over and unwind giant failed banks. The FDIC could seize a failing firm, replace its management and wipe out shareholders. Creditors would take a haircut and become the firm's new shareholders.

For this plan to work, the FDIC has said holding companies, also known as parent companies, need to issue long-term debt to creditors who could not run away when the firm got into trouble.

Fed officials are considering requiring banks to hold minimum amounts of long-term debt, also referred to as 'bail-in' debt. Researchers at the New York Fed backed that idea.

"Parent-level bail-in is quick and simple, compared to the alternatives," Joseph Sommer, an assistant vice president at the New York Fed, wrote in a paper titled "Why Bail-In? And How!"

"At worst, bail-in creates orderly liquidation."

Regulators could link the new requirement to banks' use of risky liabilities such as uninsured deposits, repurchase agreements, or repos, or commercial paper, four New York Fed researchers argued in a separate paper.

Relying on those liabilities, which are subject to runs in crises, makes bank failures costly and threatens the stability of financial markets, wrote James McAndrews, head of research at the New York Fed, and three others.

If regulators forced banks to offset those liabilities with long-term debt, the firms would have less incentive to use risky funding sources, they said.