By: Rob Nichols, President & CEO, Financial Services Forum
Yesterday, the New York Federal Reserve released a series of research papers, one of which studies whether or not large financial institutions experience a cost of funding advantage compared to their counterparts. It is important to note several deficiencies in the New York Fed’s analysis and conclusions.
First and most importantly, the New York Fed’s report focuses on twenty years’ worth of data from 1985 – 2009, which does not take into account all of the legislative, regulatory and industry initiated changes in response to the financial crisis that make the nation’s largest banks safer, stronger, and more secure. For example, bank capital and liquidity are double pre-crisis levels, balance sheets are much more solid, banks have significantly deleveraged and have submitted “living wills” to regulators. And as most recently evidenced last week, banks have overwhelmingly passed numerous stress tests imposed by the Federal Reserve, which show that they can withstand the most adverse shocks to the system. But even with the outdated, pre-Dodd-Frank data used in the study, the New York Fed found that the largest banks cost of funding advantage was only 0.31 percent, significantly less than other studies from that same time period that included implicit government support for the financial system during the financial crisis.
The New York Fed follows up this figure with the admission that any cost of funding advantage during the period they studied could be attributable to diversity and stability of large financial institutions: “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.”
Previous research has shown that large diversified institutions are less susceptible to shocks, have more predictable earnings, and this is acknowledged by the markets. The bonds of larger financial institutions are also considerably more liquid than bonds of smaller institutions. Investors are willing to pay for liquidity and predictability of earnings, which alone could support the lower funding costs.
With regard to the dated data, numerous academic studies done on the cost of funding advantage using post-crisis data have found that any cost of funding advantage large banks may have had at one time has either diminished completely, or that the largest banks are actually paying a premium in the wake of reforms to make the financial system stronger. For example:
- A recent Oliver Wyman report concludes “We do not find strong evidence that large banks derived deposit funding cost advantages that can be attributed to TBTF over the 2010-2012 period…Overall, our key findings – that the deposit rate advantages of large banks have declined significantly in the post-crisis period, and that most of the measured differences are clearly related to factors other than TBTF perceptions – are consistent with the premise that policy changes meant to combat TBTF have been effective.”
- A ClearingHouse working paper series on the value of large banks finds that, “With respect to liquidity access and deposit insurance, it is clear that large banks do not enjoy any unfair, disproportionate, or inappropriate economic benefits from these programs…Moreover, the kinds of emergency support that may be provided to the banking industry in times of crisis do not provide a disproportionate economic benefit to large banks, and a retrospective analysis of actions taken during the crisis contributes little to the present debate in light of significant statutory and regulatory changes that have since been enacted.”
- A recent Goldman Sachs analysis has found that large banks have been at a fundingdisadvantage to their smaller peers for most of 2011 and 2012: “Within the universe of bond-issuing US banks, the six largest banks did indeed experience a slight funding advantage – of just 6bp on average – from 1999 until the financial crisis began in mid-2007. The advantage widened sharply during the crisis, but then reversed to a significant funding disadvantage for most of 2011 and 2012. Today, the bonds of these six banks still trade at a roughly 10bp disadvantage to the bonds of other banks.”
- American Action Forum research on “Reconsidering Too Big to Fail” concludes, “Numerous studies have attempted to quantify the cost of TBTF; none is without potential weaknesses in empirical methods. A review suggests a new strategy for measuring TBTF costs in the future.”
Rob Nichols, president and CEO of the Financial Services Forum, discusses the impasse over the U.S. debt ceiling with Mark Crumpton on Bloomberg Television’s “Bottom Line.”
In her Sept. 18 op-ed “Scaling back ‘too big’ ” Senator Elizabeth Warren is right that enormous progress has been made since 2008 in improving the safety and stability of the financial system. Regulators have new tools to address a future crisis, bank capital has doubled, leverage has decreased, compensation practices have been aligned with long-term performance, and consumers have new protections. Warren is quite mistaken, however, on the issue of our banking system and in her proposed solution to “too big to fail.”
She ignores the fact that America’s biggest diversified commercial banks grew during the financial crisis because they proved to be a safe port in a terrible storm. The government asked Bank of America, JPMorgan, and Wells Fargo to buy their troubled peers Merrill Lynch, Bear Stearns, Washington Mutual, and Wachovia, protecting the economy from the instability arising from Lehman-like bankruptcies.
Warren’s proposed solution to the perceived “too big to fail” problem — the 21st Century Glass-Steagall Act — would make the system more risky for the taxpayer by reintroducing the standalone broker-dealer model that proved unstable and by making the mergers of large firms impossible in a future crisis. Warren herself acknowledged in May 2012 that Glass-Steagall would not have prevented the 2008 financial crisis, calling the proposed measure symbolic. We need thoughtful leadership if we are going to grow our economy and create jobs, not symbolic proposals that take us backward.
President and CEO
Financial Services Forum
Forum President, Rob Nichols, discusses how the financial system is more safe, sound than ever before on CNBC’s ‘Squawk Box’