Implicit Subsidies for Very Large Banks: A Primer

Douglas J. Elliott

Should we break up, or heavily penalize, the largest banks? This depends strongly on whether they have a major competitive advantage over smaller banks due to lower costs stemming from preferential government treatment. In particular, many observers believe that these banks pay less for their funding because depositors, investors, and trading counterparties assume that taxpayers would rescue these banks in a crisis. Since this is an unstated guarantee, it is generally referred to as an “implicit subsidy.”

The Government Accountability Office (GAO) will be issuing a report shortly, at the request of members of Congress, on the size of the implicit subsidy enjoyed by the largest banks. This primer attempts to aid readers of that report by explaining the key analytical questions that need to be addressed in deciding whether there is an overall competitive advantage for the biggest banks from preferential government treatment and in determining the size of that subsidy.

One key point to recognize up-front is that the GAO was asked to opine on a relatively narrow question that inflates the level of calculated subsidy by ignoring a number of countervailing factors. The GAO was asked to calculate the improvement in borrowing costs, but not to consider the magnitude of a number of additional regulatory requirements that have been put in place that handicap the largest banks. The net competitive advantage is the relevant figure for the most critical policy decisions.

This paper is organized around a series of questions:

  • What are implicit subsidies?
  • Why do we care about them?
  • What theoretically determines their level?
  • What do we know about them?
  • Why are they hard to measure?
  • What studies have measured the implicit subsidies?
  • What are their strengths and weaknesses?
  • What is left out of these studies?
  • Why might the subsidy levels have changed over time?
  • What could be done, if there are still net subsidies?