In the first quarter, large banks' funding advantage over smaller rivals narrowed, but the gap — which opened up during the financial crisis in an apparent reaction to too-big-to-fail policies — remained wide.

Interest expenses were 0.75% of liabilities at banks with $100 billion or more of assets in the quarter, according to data from the Federal Deposit Insurance Corp. This was 47 basis points less than the average for banks with $10 billion to $100 billion of assets and 70 basis points less than for banks with $10 billion of assets or less.

Those gaps were down from peaks of 66 basis points less than the midsize group and 101 basis points less than the small group in the first quarter of 2009 — the first full quarter after the government began its shock-and-awe campaign to avert a collapse of the financial system with the Troubled Asset Relief Program — but wider than the gaps that prevailed for much of the decade (see charts). In fact, from 2005 through 2007, funding costs at small banks were less than or about even with those at large banks.

Government backing of large institutions whose downfall would threaten uncontainable economic damage clearly suppressed their funding costs in the first quarter and helped lift their net interest margins above those of small banks for the first time in more than seven years. However, additional factors also appear to have played a role.

Large banks' advantage over rivals in rates on domestic deposit portfolios has been even bigger than for overall funding — peaking at 68 basis points less than the average for midsize institutions and 105 basis points less than for small institutions, also in the first quarter of 2009 — though about 54% to 63% of such funding has been insured at large banks since the first quarter of 2003, compared to 69% to 82% at small banks.

Still, though banks of all sizes have reduced their reliance on time deposits, whose costs fall more slowly than do transaction and savings deposits when interest rates drop, they are still far more important to small banks — about 45% of their domestic portfolios in the first quarter, compared with 19% at large banks.

Large banks have also benefited from their holdings of foreign deposits, which make up about one-fifth of their liabilities, compared with next to nothing at small banks. Interest expenses on large banks' foreign deposits fell 92 basis points from the third quarter of 2007, to 0.14% in the first quarter this year.

Of course, large banks' ability to attract foreign and other deposits generally depends on savers' faith in them, and the recent downward trend in the gap between funding costs at large and small banks could be attributed to a flattening of rates across the board. With the cost of funds for all banks having fallen to about 1%, less room exists for differentiation.

Moreover, despite legislative aspirations to attack the too-big-to-fail practice through regulatory reform, the size subsidy appears likely to endure.

In a June 3 report on the Senate bill, analysts at Moody's Investors Service Inc. wrote that they expect systemically important institutions to retain inflation of credit ratings — currently as high as five notches in some cases — though they are likely to revert, at least in the long term, to precrisis assumptions about government support.

For now, however, "challenges will remain that will restrict the regulators' ability to use" new resolution tools and impose more discipline on creditors, they wrote, noting the still-fragile economy and that "large institutions will remain as complex and interconnected as they are today for some time."


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