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GAO Must Ensure Accurate Accounting in TBTF Study

Lost in the retrospectives about the failure of Lehman Brothers five years ago is the very hopeful fact that the Government Accountability Office now is studying the "too big to fail" subsidy. It undertook this critical analysis at the behest of Sens. David Vitter (R-La.) and Sherrod Brown (D-Ohio) and a unanimous vote of the U.S. Senate.

The GAO's much anticipated report is to be delivered in two parts. The first, a backgrounder, is expected in the next few weeks. Part two, the more meaningful report, will be issued next year. We must be sure GAO's calculations are accurate to fully account for the taxpayer-funded advantages the major banks enjoy. Some have referred to that subsidy as "the ongoing bailout" of the TBTF banks.

Specifically, the investigative arm of Congress is examining whether banks with more than $500 billion in assets can raise funds more cheaply than smaller institutions due largely to the major banks' distorted credit ratings attributable to the taxpayers making unsecured creditors of those banks whole in times of financial stress. Notwithstanding the good intentions of the Dodd-Frank Act, the "too-big-to-fail" dilemma lives on and along with it the rich benefits of being TBTF.

What makes the GAO study so important is that it goes to the very heart of how we understand our "too-big-to-fail" problem and its effect on our financial markets. We need to clearly analyze how the markets price in that competitive advantage so we can better understand what to do about it. That means that the GAO should be using the right data to fully account for this taxpayer-funded benefit.

One area where the GAO must tread carefully is in calculating the costs to these firms of dealing with their bad bets and risk-management failures. Because of their government backstop, the largest financial firms have an incentive to take excessive risk, knowing they have the full faith and credit of the United States of America as collateral. It's the age-old issue of "moral hazard."

In arriving at the total taxpayer-bestowed "too-big-to-fail" benefit, the GAO should not deduct the added costs of compliance and penalties these firms incur due to their operational failures.

For instance, if the GAO determines that the TBTF subsidy amounts to $83 billion a year, as Bloomberg determined based on a study done by two International Monetary Fund economists, no deduction should be made from that amount for large bank compliance costs and penalties.

JPMorgan Chase, for example should not offset against its taxpayer subsidy the $920 million in penalties it has to pay following its "London Whale" episode in which the company incurred a $6 billion loss on trades funded partly by federally insured deposits and subsequently misinformed investors, regulators, lawmakers and taxpayers about it. The same applies to HSBC and its mammoth anti-money laundering fines.

Such are the costs of being unmanageable, and they do not come close to internalizing the negative externalities associated with the "too-big-to-fail" model.

Finally, there is the related matter of the major banks' exemption from our nation's criminal statutes a policy articulated by Attorney General Eric Holder. There is substantial economic value in this exemption. Admittedly, it's not easy to model. But if the GAO does not include it in its measurement of the subsidy it is assigning a value of precisely "zero" which ignores its reality and passes the cost of that benefit entirely on to the taxpayers.

Here's a possible approach: Have the insurance industry tell us what it would cost each major bank to insure itself against criminal charges. The cost of those insurance premiums may not be the final answer regarding the economic value of criminal immunity, but it would be much closer to the truth than zero. Hopefully the GAO will take notice.

Taxpayers already have been required to open up their wallets to keep these financial giants in business to prevent catastrophic collapse. They should not also have to foot the bill for the operating costs of the business model these financial firms have chosen. In other words, the GAO should focus on the gross benefit of being TBTF, not the benefit net of fines, penalties and regulatory burdens.

The whole point of addressing our "too-big-to-fail problem and its market distortions is to ensure free-market principles apply consistently across our financial system. To do so, we must be consistent as we dissect the issue. Neither the benefits nor the costs of being "too big to fail" should be borne by taxpayers.

Professor Cornelius Hurley is director of the Boston University Center for Finance, Law & Policy. Views expressed here are not necessarily those of Boston University or his colleagues.

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Well, I do have the courage to say that there are no banks in the U.S. that are too big to fail. And I am equally confident to say that none should be. The easy thing is to pretend that TBTF still exists. That is the popular mythology. The world has changed in the last few years, and the willingness of regulators--for now--to keep large failing firms open has very much eroded, and the tools to unwind them carefully have increased. Those pieces of paper are called laws. We live by laws in this country, or at least perhaps I am naive enough to believe that we do.
Posted by WayneAbernathy | Wednesday, September 25 2013 at 4:11PM ET
Prof. Hurley is absolutely correct when he says that TBTF still exists. The Goldman study noted above almost concedes in its report the major reason its conclusions are flawed--that the universe of banks that issue bonds is so small that comparisons can't be made between one TBTF bank and another. This is one of the reasons why other academic studies included a wider universe of companies, including both nonfinancial companies as well as banks, when comparing bond rates. Those other studies have shown a significant TBTF subsidy. Furthermore, outside of bond rates, Goldman does not even address the studies that show the clear funding advantage the large banks have over the smaller banks, nor does it mention the incredible hardship that community banks have to raise either their debt or equity.
But Prof. Hurley is also right that the GAO should consider insurance costs when considering the amount of the TBTF subsidy. When a community bank fails, that bank's directors have about a 25% chance that they will be sued by the FDIC. That is one of the reasons why community banks are having difficulty finding good directors. Does a Citibank director worry about its bank failing and being sued by the FDIC?
Posted by Chris.Cole@icba.org | Wednesday, September 25 2013 at 4:07PM ET
Mr. Abernathy's comment reminds me of Studs Terkel's remark when asked about his religion, "I'd say I'm an atheist but I don't have the courage." The Abernathy version in the context of TBTFs would be to say, "I'd admit they exist (like everyone else does) but I don't have the courage."
Posted by LetsGetReal | Wednesday, September 25 2013 at 3:57PM ET

Mr. Abernathy states that he knows of no American bankers who agree with TBTF doctrine or practice. The ten largest mega-banks have combined assets of $11.3 trillion - 28% higher than five years ago - yet Mr. Abernathy would have you believe that these American bankers don't cherish their Too Big to Fail status. Makes one wonder why American mega-bankers have hired a veritable army of lobbyists to storm Capitol Hill. Are they ready to give up their legal immunity from being Too Big to Jail as well?

Mr. Abernathy further stretches the limits of credulity by stating that "I don't think that there are any banks in the U.S. today that the regulators would not shut down if they were failing." The government of the United States moved heaven and earth to keep them open five years ago, and they have only gotten bigger and more unmanageable. Reminiscent of former British Prime Minister Neville Chamberlain, Mr. Abernathy waves the Dodd-Frank piece of paper, as if it is sufficient to bring peace in our time.

When Chamberlain wrapped up his post-Munich display of naivety, he advised his countrymen to "go home and get a nice quiet sleep". No doubt Mr. Abernathy would like for community bankers and other critics of the systemically dangerous Too Big to Fail, Too Big to Jail mega-banks to do the same thing, leaving the legion of mega-bank lobbyists to shape the narrative.

Well, that's not going to happen.
Posted by PrestonKennedy | Wednesday, September 25 2013 at 3:36PM ET
How should the GAO calculate the "the ongoing bailout" of large banking institutions? The author is right to state that the GAO should ensure accurate accounting because, currently, there are a lot of flawed ways of looking at the data. In fact, the author decided to use one of them -- the $83 billion Bloomberg study. Here's why it's flawed:

First, this back-of-the-envelope calculation looks at credit ratings over real-world bond pricing. The latter studies reveal that there is no funding advantage over smaller peers. Actually, there is a funding disadvantage since the crisis.

A Recent Goldman Study Reveals That Government Support Ratings Have Diverged From Market Prices. "In our view, the link between credit ratings and funding costs may not be as clear or certain as these arguments suggest. While bond-spread performance is frequently driven by near-term market dynamics, ratings take a different time horizon; they are intended to give a longer-term view of credit fundamentals and they typically lag market assessments. This is certainly true in the banking industry, where market prices and ratings have diverged considerably since the crisis began in mid-2007."(Steve Strongin, Measuring The TBTF Effect On Bond Pricing, Goldman Sachs, 5/13)

According To Goldman, Bonds Of Large Banks Are Now Trading At A Funding Disadvantage To Smaller Peers. "Within the universe of bond-issuing US banks, the six largest banks did indeed experience a slight funding advantage - of just 6bp on average - from 1999 until the financial crisis began in mid-2007. The advantage widened sharply during the crisis, but then reversed to a significant funding disadvantage for most of 2011 and 2012. Today, the bonds of these six banks still trade at a roughly 10bp disadvantage to the bonds of other banks." (Steve Strongin, Measuring The TBTF Effect On Bond Pricing, Goldman Sachs, 5/13)

Second, these same credit rating agencies used in the Bloomberg calculation recently stated they are updating their government-support ratings in order to take in to account the diminished likelihood of future government bailouts.

Moody's Acknowledges Progress On Regulatory Reform. "Moody's Investors Service has placed the senior and subordinated debt ratings of the holding companies for the six largest US banks on review as it considers reducing its government (or systemic) support assumptions to reflect the impact of US bank resolution policies." ("Moody's Reviews Us Bank Holding Company Ratings To Consider Reduced Government Support," Moody's Investor Service, 8/22/13).

And lastly, as Bloomberg's own Charles Mead reports, market participants were ahead of credit ratings in their assessment that banks were less likely to receive government support.

The Swaps Markets Are Recognizing That Large Banks Are Less Likely To Be Bailed Out. "UBS strategists led by Robert Smalley also expect Moody's to cut its ratings by one level as the probability for state support diminishes, according to an April 2 report. That would leave creditors of the holding company more vulnerable to losses as regulators develop an alternative strategy. 'The swaps market is beginning to acknowledge that,' Smalley, based in New York, said in a telephone interview." (Charles Mead, "Too Big To Fail Discounted As Moody's Evaluates: Credit Markets," Bloomberg, 4/10/13).
Posted by @Patrick_J_Sims | Wednesday, September 25 2013 at 11:39AM ET
Mr. Wilcox apparently has no confidence in the integrity of GAO and its processes. I have a higher opinion.

Mr. Wilcox seems to want a GAO study of TBTF that begins by ratifying his opinion of TBTF. I would prefer a GAO study that begins by approaching the issue with an open mind.
Posted by WayneAbernathy | Wednesday, September 25 2013 at 11:03AM ET
Thank you Professor Hurley for your courage and articulate expression of what will be a significant report by the GAO.

Let's get real here for a moment, Mr. Abernathy would seem to suggest we have not determined if these Wall Street mega banks are TBTF. We have codified that notion, both in Dodd/Frank and in testimony by various individuals including Chairman Bernanke. Additional AG holder has taken that further by acknowledging their additional status as TBTJ. So suggesting that we need to determine that before the GAO determines the extent of the subsidy is simply absurd. (Although not surprising, given the source)

These banks in essence "failed". The free market system of trading proved that no investors wanted in on their greed and risk taking activities, and so government put a gun to the temple of every tax paying American and forced the issue. This not only demonstrated the existence of TBTF/TBTJ it perpetuated it in dramatic fashion. The fact that the taxpayers were now "paying" for the casino style risk taking of the biggest banks led to increasingly reckless and risky behavior and has allowed the TBTF crowd significant funding advantages over the community banking sector.

Professor Hurley is entirely correct that the penalties and compliance and regulatory costs that have resulted from the TBTF risk taking activity should not be excluded in the calculation of their subsidy. To do so would only further the TBTF problem.

TBTF lobbyists are no doubt camped out on the GAO's doorstep and using every last trick in the book in the attempt to avert the truth. Hey, if you can manipulate an energy market, perhaps they believe they can manipulate the GAO as well - let's hope not.

The GAO needs to stand tall, strong and independent and consider the facts truthfully and without prejudice or undue influence from the TBTF/TBTJ. It is time to end the systemic risk these banks pose to the world economy as well as the health of American taxpayers.

Noah Wilcox
Posted by grsb | Wednesday, September 25 2013 at 10:54AM ET
Con, I in fact do agree that there should be no TBTF doctrine or practice in America. I know of no American bankers who disagree with that.

I will also say that I don't think that there are any banks in the U.S. today that the regulators would not shut down if they were failing.

The GAO has been asked to test whether that is true. I believe that the flaw in your argument is that it requires GAO to begin by positing that TBTF exists as the basis for its study as to whether it exists or not. If you are going to begin with the assumption that there remain TBTF banks and a TBTF policy, then you do not need to have GAO study the question.
Posted by WayneAbernathy | Wednesday, September 25 2013 at 10:53AM ET
This is an existential issue first and a competitive equity issue second.

We can all agree (even Wayne Abernathy) that we don't want TBTFs to exist. Given this policy objective, any financial reward for being TBTF is contrary to public policy. Why on earth should we provide offsets against those financial rewards for the costs of ameliorating the systemic harm that they impose? Cornelius Hurley, Boston University
Posted by hurley | Wednesday, September 25 2013 at 9:56AM ET
This argument seems to me a tautology. It in effect posits that large banks are too big to fail and "too big to manage," and then argues that GAO should assume that to be true while investigating whether TBTF exists or not. The argument is that because TBTF banks are TBTF don't include the cost of being TBTF in determining whether they are or not.

A more objective approach might be not to assume the conclusion of the study and instead look at all factors, all costs and benefits, from size and scale of operations. Familiarity with other GAO efforts would lead one to suppose that they will opt for objectivity.
Posted by WayneAbernathy | Wednesday, September 25 2013 at 9:22AM ET
Thank you Professor Hurley for the courage to speak up and challenge the incredible power of Wall Street! I can imagine that the GAO is under tremendous pressure to low ball the value of the TBTF subsidies as Wall Street and K Street have taken up residence on their doorstep. And yes, it will be incredibly difficult to put a number on the value that JP Morgan's C-suite gets from their ability to claim they were too far removed from the immoral and illegal activity of their lowly staffers, even as they authorize their bank's payment of billions in fines and legal defense fees. And all the while regulators continue to pursue community bank directors for their entire life's work, scorning them through press coverage and removal from the industry because they are too small to matter. It is shameful and I only hope that the GAO will have the guts to not give in to the enormous forces of financial power that drove our economy to ruin just 5 short years ago.
Posted by tjorde | Wednesday, September 25 2013 at 9:15AM ET
Exactly!
Posted by Lawrence Baxter | Wednesday, September 25 2013 at 9:13AM ET
Professor Hurley nails it! The GAO should not succumb to the TBTF Mega Bank lobby. TBTF banks should not get credit for having grown so large that they are too big to manage and control. GAO should tell it like it is - that TBTF banks receive taxpayer subsidies for their reckless behavior. They should not be rewarded in the GAO study for the chaos they themselves have created.
Posted by commobanker | Wednesday, September 25 2013 at 8:38AM ET
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