Inside Financial Services

The Myth of the Too-Big-Too-Fail Subsidy

It should show up as a lower cost of funds for the big banks--but does not

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The drumbeat seems to be getting louder every day that, to get a handle on the problem of too-big-to-fail, the government needs to do something about the big banks. Critics gripe in particular that the implicit government backing that TBTF provides big banks amounts to a subsidy ($83 billion worth, by some counts) that gives them an unfair advantage over smaller lenders.

Eighty-three billion dollars is a lot of money! One would think an advantage that large would show up in the big banks’ numbers-most notably, in a lower cost of funds relative to smaller lenders.

So we ran some numbers. In particular, we calculated the total all-in cost of funds for each of the country’s 100 largest banks, by tallying the cost of each bank’s deposits, debt, preferred, and common. If what the big-bank skeptics say is true, the purported TBTF subsidy should mean that the largest banks should have a cost of funds that is systematically lower than other banks’. Makes sense right? Here’s what we found:

And Elizabeth Warren wept. Yes, you’re reading the chart right: the cost of funds at the biggest banks is no different from that of all banks, even ones without implicit government backing. (Actually, if anything, the big banks’ cost is a little bit higher: the average cost of funds at the Big 4 comes to 1.84%, for instance, vs. 1.36% for all 100 banks.) If there really is a TBTF subsidy, it’s hard to see it from here.

A couple of comments, by way of explanation:

We calculated the cost of common based on CAPM using a 1.7% risk free rate, each individual bank’s beta, and a 7% assumed market return.

Some people will argue that deposits should not be included in the calculation. I don’t buy that. Here’s why: if the argument over TBTF is that big banks enjoy an inherent subsidy, there’s no reason to think that subsidy shouldn’t show up as a lower cost of deposits, since depositors (like the rest of the bank’s creditors) can be expected to accept a lower rate in return for the safety against failure. It’s not as if big banks have historically been automatically immune to runs.

People might also argue that the total cost of funds as calculated here is skewed because of the relatively large proportion of debt at large banks. No. If the TBTF subsidy is as sizable as bank critics say, it’s going to extend across the bank’s entire capital structure (debt and deposits included).

So as regards any TBTF subsidy, the critics are simply wrong. Regular readers know I’ve made something of a career of bashing the big banks. But my objections have been that big banks are inherently difficult to manage well, and that too often they become vehicles for the self-aggrandizement of incompetent or monomaniacal CEOs (Ken Lewis and Hugh McColl, I’m looking at you) at the expense of shareholders. But bigness in and of itself is neither inherently bad nor destabilizing. Just the reverse: the largest institutions tend to be the most diversified across business lines and so are better able to withstand shocks. Nor are all big banks poorly run. If you doubt it, just take a look at Wells Fargo or U.S. Bancorp.

Now the evidence shows that objection du jour to bank bigness, the supposed TBTF subsidy, is a myth. Bank critics will continue their braying, of course. That’s what they do. But it’s becoming increasingly clear that, as regards cold facts and data, they don’t have a whole lot to complain about.

What do you think? Let me know!

14 Responses to “The Myth of the Too-Big-Too-Fail Subsidy”

  1. Larry Horan, SBHU alumni

    Too many lawyers are setting policy based on their belief systems regarding “fairness.” They know jackshXX about How the economy and financial markets work.

  2. jsc173

    Not sure cost of funds is the issue. Isn’t the real issue the sense that, much as we saw with Fannie and Freddie, the TBTFs have the implicit backing of the governement and the “internal” effect — how that affects the behavior of the banks themselves — is more potentially impactful than the “external” effect — how that might lower their cost of funds/capital? In other words, they will be less risk-averse and be more susceptable (yet again) to tail event risk.

  3. rivvir

    Perhaps a flawed premise and a useless exercise, perhaps you’re correct. The problem i see is you’re presuming banks are run efficiently and the costs each incurs is outside of its own control. I don’t have enough faith in that being a correct presumption. I’ll refrain from using assumption. If i put 100% faith in your presumption without devoting more time to taking it apart and putting it back together again, a task i’m unwilling to take on, then i’d use the other word.

  4. JMB

    Tom, as always, interesting analysis. One major objection to your argument, however, deals with deposits. The cost of deposits is ALREADY skewed by deposit insurance–in effect a subsidy to ALL banks, not just TBTF. Moreover, are depositors really concerned about the safety of their deposits, even if they exceed the insurance limit? When was the last time a depositor in the US lost any part of his deposit in a bank failure?

    So I agree with those who would separate deposits from the analysis. But your argument also serves to highlight the difficulty of quantifying the subsidy. In fact, the subsidy may be less quantitative than qualitative. Because of TBTF, Citi, BAC, Wells, US Bank, JPM, etc. enjoy greater access to the debt markets. Part of the reason, no doubt, is merely their size. But if I’m buying bank debt, my safer option–without question–is a TBTF bank and I’m accordingly more willing to accept lower rate because I know the federal government is absorbing some of my risk.

  5. JMB

    Tom, as always, interesting analysis. One major objection to your argument, however, deals with deposits. The cost of deposits is ALREADY skewed by deposit insurance–in effect a subsidy to ALL banks, not just TBTF. Moreover, are depositors really concerned about the safety of their deposits, even if they exceed the insurance limit? When was the last time a depositor in the US lost any part of his deposit in a bank failure?

    So I agree with those who would separate deposits from the analysis. But your argument also serves to highlight the difficulty of quantifying the subsidy. In fact, the subsidy may be less quantitative than qualitative. Because of TBTF, Citi, BAC, Wells, US Bank, JPM, etc. enjoy greater access to the debt markets. Part of the reason, no doubt, is merely their size. But if I’m buying bank debt, my safer option–without question–is a TBTF bank and I’m accordingly more willing to accept lower rate because I know the federal government is absorbing some of my risk.

  6. Strongboy

    Am a CPA and long time reader, your and other financial folk. Have always come away with the thought that the Libs, progressives, socialists commies whatever you call them lie about their motives and their statistics. You got to make the story fit your misguided programs. So it is no surprise that the TBTF stuff is their usual lies. Recently, I have observed that since this Administration is having a hard time getting tax/revenue increases from Congress, they just decide a bank or any other business is in violation of some of the thousands of pages of conflicting regulations and fines a Brazilian $. Green mail at the highest level,

    Keep pointing out lies wherever you find them.

    Thanks

  7. PMM

    Tom, I agree with your analysis. What troubles me is this misplaced Dodd-Frank regulation and drumbeat to
    break up the big banks. The regulations make it nearly impossible for small community banks to operate at
    a profit. They do not have the resources to comply with the regulations. Most don’t even have the expertise to
    even understand the regulations. The big banks have an even larger advantage in that they can afford to comply
    and grow by absorbing the failed smaller banks. Now the Dodd-Frank supporters wand to break up the large
    banks for what. Maybe they can cause the entire system to fail. Is that the plan??? PMM

  8. DSB

    Tom, thanks for another thought provoking post. And yes I have been in the audience when you have pilloried the big banks (and Ken Lewis) so I know there is not a bias for these banks coming through in the analysis. However, is it “all banks” as stated above or just the next 96 largest banks against which the 4 TBTF do not show a discernible subsidy? Can we assume that the source of the borrowing – bank versus bank holding company – is consistent (controlled for) against all 100 banks in the study? [The TBTF bank holding companies are all lower rated than their insured banks. If the TBTF banks fund more at BHC level than smaller banks and rates are the same wouldn’t that be indicative of a subsidy?] Also, does your analysis take into account the level of derivatives at the TBTF banks relative to the next 96 or banks beyond the top 100? As of 12/31/2012 JPM Chase Bank had total assets of $1.9T, but derivatives were 36x total assets at $69T. Bank of America had total assets of $1.5T and derivatives of $43T (29x), Citibank had total assets of $1.3T and derivatives of $56T (43x), while Wells Fargo Bank had total assets of $1.3T and derivatives of $4T (3x). As of 12/31/2012 all commercial banks in the US had total derivatives of $224T and Chase, BofA and Citi with $168T amounted to 75% of the total. Bringing in Goldman Sachs Bank with $118B of total assets snares another $41T (345x) of derivatives exposure and represents about 95% of all derivatives in commercial banks. I realize this is notional and in a world of unicorns and fairies the exposure nets to “zero”, but it only does until it doesn’t. We all know that none of the supposed analysts knew Bank One had derivatives exposure until they did in 1994. I seriously doubt the “smart guys” are calculating risk associated with the derivatives on the books of the TBTF banks. My take – the TBTF banks are borrowing below their proper risk weighting whether it is due to an explicit TBTF subsidy or an inefficient market.

  9. barrydemo

    Very interesting, I would have thought that that had an advantage.

  10. Jersey Wall

    If anything, you underestimate the cost of deposits to the largest banks. Banks pay for deposits not only to depositors but also in terms of premiums to the FDIC. All things being equal, this would be the same for all banks. But here all things are not equal. All banks, after Dodd-Frank pay premiums to the FDIC not based upon how much they have in deposits but how much they have in assets, regardless of whether the assets are fully or only partially funded by deposits. FDIC statistics show that the smaller the bank, the more it relies upon deposits for funding. Small banks fund as much as 75% or more of their assets via deposits. Large banks, about 50% (some, much less). So the larger banks pay an outsized share of the total bill for deposit insurance when compared with their share of insured deposits. With the total FDIC tab being about $12 billion a year, that outsized share numbers in the billions of dollars.

  11. John Tschohl

    Tom I love reading your stuff. You are candid and always do a great job.

  12. Randall Grossman

    Of all the false “lessons learned” from the recent banking crisis, “Too Big to Fail” is unquestionably the worst. As Tom points out, large banks tend to be sufficiently diversified to be able to absorb very large losses in a particular business (case in point: Chase and the London Whale). Further evidence is the fact that of the banks that the FDIC took over (or forced a sale) due to insolvency over the last few years, almost all were smaller institutions. Furthermore, the few larger banks that failed required that a lower percentage of their deposits be redeemed from FDIC funds than was the case with smaller banks, where the losses were large as a percentage of the deposit base. In short, it is less risky for the FDIC to ensure large banks than to ensure small ones.

    The government — and taxpapyers — benefited from the existence of large banks during the depths of the financial crisis. The crisis was not about the insolvency of a few TBTF banks, it was about the potential collapse of the entire banking system due to uncertainty and fear. The American people benefited from the fact that the Secretary of the Treasury could work with a small number of banks to blunt that fear and stabilize the system. And the Amercian taxpayers have benefited from the fact that those same banks have absorbed tens of billions of dollars of mortgage losses that would have bankrupted smaller banks.

    I do not mean to excuse the stupidity of mortgage lenders — public and private — who extended credit far beyond the point of sensibility The losses they incurred were deserved. And I share the outrage that while shareholders and the FDIC paid the price of lenders’ irresponsible behavior, many of the executives who made those decisions never had to pay back the large bonuses they were paid prior to their errors becoming evident — including the executives of the hundreds of small banks that failed and left their losses to the government to pay for. Creating laws that would p

  13. Ron

    Being a TBTF critic (small banker), I’m more interested in just comparing deposit costs only (including FDIC insurance premiums). Did your analysis include that, and if so what does it show?

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