I feel like I’m on the “the too-big-to-fail subsidy is negative!” beat, even though I only kind of believe it, so in that spirit here is a fun paper from Goldman Sachs’ Global Markets Institute1 that finds that the too-big-to-fail subsidy is negative. That is, Goldman concludes, contrary to popular belief, that the biggest U.S. banks actually don’t have a funding advantage over smaller banks due to the possibility that they’ll be bailed out by the government. Here is the money picture:
If that’s hard to read: the bonds of the six biggest U.S. banks – the ones whom everyone thinks the government would rescue if they blew up, JPM-C-BAC-GS-MS-WFC – yielded on average 6bps more than the average non-TBTF-bank bond before the start of the crisis in 2007. They traded hundreds of basis points tighter during the crisis (TBTF subsidy!), but now are back to trading wider:
In fact, over much of 2011 and all of 2012, the biggest banks’ bonds traded at significantly higher rates than other debt-issuing banks’ bonds—as much as 147bp more at times of significant market stress. Notably, the funding disadvantage during this period was significantly wider than any advantage the largest banks had enjoyed before the crisis, and likely reflected bondholders’ concerns that they might suffer punitively high losses if regulators chose to liquidate a troubled big bank at that time. These concerns began to subside in the second half of 2012, with the emergence of the outlines of the new bank-resolution protocol oriented toward imposing losses on shareholders and creditors rather than on taxpayers. Today, the biggest banks’ bonds still trade at rates that are roughly 10bp higher than those of other bond-issuing banks, meaning that they still experience a funding disadvantage.
So the 1999-to-present average funding advantage for TBTF banks is, according to Goldman, 31bps.2 This is a little under half of the 80bps that Bloomberg used in calculating their much-quoted $83-billion-a-year TBTF subsidy. Goldman didn’t calculate aggregate numbers, but just scaling by Bloomberg’s I’m going to say Goldman thinks the too-big-to-fail subsidy is:
- $32 billion, on average, 1999-present, but
- negative $10 billion today.3
This part of the Goldman report should convince nobody! I mean, it’s just “bigger banks pay a higher interest rate on their bonds than smaller banks.” The trick is to untangle:
- Bigger banks pay lower interest rates because they are more diversified, bigger companies are usually safer, and their bonds are more liquid;
- bigger banks pay lower interest rates because some people expect them to be bailed out by the government;
- bigger banks pay higher interest rates because they are more aggressive, more risk-seeking, more prop-trading-y, etc.; and
- bigger banks pay higher interest rates because some people expect the government to be more rigorous about imposing losses on bondholders in a big-bank failure than in a small-bank failure.
Surely all of those things are true simultaneously. Bloomberg, to its credit, tried to extract the bailout-expectation one to get to its $83bn number; to its discredit, it did so by blindly and sort of wrongly using Fitch ratings to measure both bailout expectations and their value.4
Goldman mostly doesn’t try to disentangle those things in any quantitative way,5 which makes the result sort of meh: big banks fund a touch more expensively than small banks, but whether that means the too-big-to-fail subsidy is negative or nonexistent or just counterbalanced by other risks remains an open question. (Though they make some points suggestive of the “negative or nonexistent” side, like that the biggest companies in most other industries have a bigger funding advantage over their peers than the biggest banks have over theirs, or like that big-bank bonds are literally 20x more liquid than wee-bank bonds and so should get a liquidity premium.)
More interesting, maybe, is the second part of this paper, where GS argues that big-bank failures tend not to cost the government anything, unlike small-bank failures: big banks tend to have lower realized losses when they fail in the FDIC-shutdown sense, and then of course there is TARP:
This is shoehorned into an argument that big banks should have a funding advantage because they’re safer – i.e. less likely to impose losses on creditors, even without bailouts – but I’m not sure it’s about that. Surely the real point is to soothe fears about too-big-to-fail: don’t worry, bailouts don’t really create a subsidy for big banks, and they make money for taxpayers.
And of course they do. Here’s a timely reminder that:
Most investors suffer from the problem that their investments are most likely to lose value precisely when the investors themselves are most likely to be in dire straits. If the stock market is collapsing, for example, then the chance of you becoming unemployed goes up. You can only get at your money out precisely when you don’t need it.
From a purely blackboard point of view the US government has the opposite situation. Student loans for example, are most likely to experience high default rates precisely when the government is most likely to see its costs of borrowing collapse. To the extent that’s the case, market risk for the US government is negative. This is why the bank bailouts for example, had the curious feature that the government shoves money at collapsing institutions and gets more money back.
Exercise for the reader: should the government6 prefer for big banks to be very volatile? Buy low, sell high, over and over again. Who needs capital requirements?7
Anyway, though, it’s a neat argument: big banks don’t get any funding advantage from the prospect of bailouts, because nobody believes that there will be bailouts. And bailouts are profitable to the government and work out just great. Which is why they’ll never happen. Hmm.
Measuring the TBTF effect on bond pricing [GS Global Markets Institute]
Should The Government Use Fair Value Accounting [Fortune]
Earlier: pt. 1, pt. 2
1. Which is like a … research-lobbying hybrid? From the report:
The Global Markets Institute is the public policy research unit of Goldman Sachs Global Investment Research. Its mission is to provide research and high-level advisory services to policymakers, regulators and investors around the world. The Institute leverages the expertise of Research and other Goldman Sachs professionals to offer written analyses and host discussion forums.
2. When I redid Bloomberg’s numbers I calculated that their sources supported a 31bps subsidy, but the match there is purely coincidental. Different time periods etc. etc. etc. etc.
3. That’s just on bonds, though. I calculated it, somewhat tongue in cheek, at negative $16 billion today, because I took into account the fact that big banks tend to use more (expensive) bond funding and less (cheap) deposit funding than little banks. GS agrees but doesn’t quantify:
It is worth noting that the lack of bond funding for smaller banks does not give them a relative funding disadvantage. This is because their business models generally allow them to fund themselves almost entirely through deposits, which are even cheaper than the bond funding costs for the largest banks. In today’s low-interest-rate environment, rates paid on deposits are just 40-82bp, compared to average bank issuance yields in the bond market of 235bp in the first-quarter of 2013, meaning that it is the small banks rather than the largest that have an overall funding advantage.
4. The Goldman paper has an appendix trying to debunk competing TBTF-subsidy research for various perceived flaws, including over-reliance on ratings agencies. Also this:
[S]everal papers rely on data on banks from countries with banking industries as different from the US as those of Albania, Qatar and Uzbekistan. In some cases, US banks comprise only a small portion of the total sample. While comprehensive, it is not clear that these calculations should be applied to the US banking industry given the differences in banking systems, financial markets and local economies across such a wide range of other countries.
So, obvs, if you’re reading this in Uzbekistan none of this necessarily applies to you.
5. Which, TBF, seems hard? This seems like an interesting, somewhat counterintuitive, not-exactly-on-point-to-this-discussion approach.
6. U.S. NOT GREEK. Or Cypriot. Or … European, I’m gonna say, generally. Something something own currency.
7. Answer: obvs, no, but it’d be really easy to make money in the financial markets as the U.S. government, if that was your only priority. Just the insider trading alone.