Fed Economist Says Big Bank Borrowing Advantage Increases Risk

By Cheyenne Hopkins and Craig Torres

March 25 (Bloomberg) -- The largest U.S. banks, including JPMorgan Chase &
Co. and Citigroup Inc., can borrow more cheaply in bond markets than smaller
rivals, in part because of investor perceptions that they are too big to fail,
according to a Federal Reserve Bank of New York researcher.
The five largest banks pay 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 Media
the government if they get into trouble.
Bigger Discount
The study also found that the largest banks enjoy a funding-cost advantage over JPMorgan
large non-bank financial firms as well as the biggest non-financial corporations. Chase & Co.
This finding suggests that “investors believe the largest banks are more likely to NY Offices
be rescued if they get into financial difficulty,” according to Santos.
The five largest banks by assets are JPMorgan Chase & Co., Bank of America
Corp., Citigroup Inc., 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.
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.
Other Reasons
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.
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.”
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.
Reducing Odds
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.
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 2010 Dodd-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.