On November 14, 2013 Moody's Investors Services made an important announcement. They reviewed their credit ratings assessments on the eight largest U.S. banks and "removed all uplift from U.S. government support in the ratings for bank holding company debt." This marks the beginning of a new chapter in the too big to fail issue.
Big banks should not have an unfairly low funding cost because of assumptions in the market that the government will rescue them in a crisis (often called an "implicit subsidy" from the government.) There is a broad consensus on this point, including among the bankers themselves. In the financial crisis the shareholders of banks took substantial losses, appropriately so, but most debt holders were protected from losses. This was done for good reason, so that the financial system did not collapse and further harm the rest of the economy, but it created a problem where buyers of bank-issued debt may believe they will be protected again in a future crisis. A policy that was necessary in the crisis could create "moral hazard" if it distorts the market price of bank bonds.
Fortunately, financial regulators have changed the rules to eliminate unfair funding advantages. Under Dodd-Frank the Federal Deposit Insurance Corporation (FDIC) was charged with developing a process for resolving large banks (letting them fail) without protecting the owners of the bank, while at the same time avoiding disruption of the whole financial system. That is a tall order, but it looks like they are succeeding. They have developed a proposal that would place the costs of bank failure squarely on the shoulders of the shareholders and the unsecured long-term debt holders of the holding companies of large banks. This can be done while keeping a troubled bank's operating subsidiaries open for business and serving customers under the control of an FDIC-appointed trustee. It may also be possible to expand the use of bankruptcy proceedings for large banks, with an amended bankruptcy code that is designed for such institutions. Several of the large airlines have been through bankruptcy without major disruption to airline passengers or the economy and the same may be possible for large banks.
There is skepticism among some financial experts around whether or not the FDIC resolution plan would really work for a huge failing bank. We will not know for sure unless a new crisis occurs, and we certainly do not wish for that. In terms of a funding cost subsidy, the key point is that regulators are requiring that big banks hold a substantial amount of long-term unsecured debt at the holding company level and that when this debt is sold in the market investors will know that it will be in default in the event of a failure of the bank, or even in a bailout if it were to come to that. Both markets and the rating agencies are catching on to the regulatory change and realizing that bondholders now face possible losses and must price these into market interest rates. This means that any unfair subsidy, or almost all of it, has been taken away.
This is not the only regulatory change that affects the big banks. In line with the international rules being formulated in Basel, U.S. regulators are requiring that systemically important banks hold additional capital above the level required of smaller banks. Holding that extra capital makes the big banks safer but it is also expensive and creates a funding cost penalty for them. Large banks are facing other regulatory burdens aimed specifically at them, starting with heightened regulatory scrutiny from the Federal Reserve. Beyond that, they will be penalized in regard to the Volcker rule outlawing proprietary trading, new margin requirements, and limits on counterparty risk. The final derivatives rules likely will also affect large-bank funding costs. These various burdens likely already more than offset any remaining advantage in the cost of raising debt due to assumed government support.
It will be up to the empiricists to estimate whether or not large banks have a funding advantage, or perhaps a funding penalty, because of regulation under the new rules. A number of existing empirical studies have looked at large banks overseas and at historical evidence from the United States. Since most countries do protect their large banks, it is not surprising that there is evidence of a funding cost advantage for large banks in other countries. Historically, large American banks may have had a funding advantage too because of implied government support. It is hard to know this for sure or to assess exactly where relative funding costs are today because large companies in any industry pay lower interest costs. Large companies are more diversified in the products and services they sell, which makes them safer, and they have bigger bond issues, which lowers trading costs and makes them more attractive. It is not clear that the purported subsidy for large banks is anything more than this generic size advantage applied to the banking industry, without an implication of government support. Further, recent evidence does indicate that the interest rates paid on bonds issued by large bank holding companies have risen as markets realize the new risks these bonds face. Once Dodd-Frank has been fully implemented, and once markets have fully understood the impact of the new rules, it will be possible to get better estimates of funding costs.
One of the strengths of the American financial system is the range of different banks: small local banks, regional banks and the large money-center banks. These play different and valuable functions in the economy, functions that are sorely needed in a continued weak recovery. The first priority of bank regulators is safety, but they should also be mindful of keeping a level playing field, allowing banks of different sizes to compete and provide the services customers want. It is important to avoid an excessive regulatory burden that would make small banks uneconomic, but also to avoid populist pressure to destroy the large banks that are competitive globally and provide essential services to large American companies and many other firms and households.