How Much Did Banks Pay to Become Too-Big-To-Fail and to Become Systematically Important?

In the paper, How Much Did Banks Pay to Become Too-Big-To-Fail and to Become Systematically Important? which was recently made publicly available on SSRN, we estimate the value of the too-big-to-fail (TBTF) subsidy. The special treatment provided to too-big-to-fail institutions during the financial crisis that started in mid-2007 has raised concerns among analysts and legislators about the consequences of this for the overall stability and riskiness of the financial system. Stern (2009) testified before the Committee on Banking, Housing, and Urban Affairs that “TBTF arises when the uninsured creditors of systemically important financial institutions expect government protection from loss … If creditors continue to expect special protection, the moral hazard of government protection will continue. That is, creditors will continue to underprice the risk-taking of these financial institutions, overfund them, and fail to provide effective market discipline. Facing prices that are too low, systemically important firms will take on too much risk. Excessive risk-taking squanders valuable economic resources and, in the extreme, leads to financial crises that impose substantial losses on taxpayers.”

It was unclear after FDICIA and before the financial crisis whether some banking organizations were TBTF. It is now evident that being viewed by the market (and regulators) as being TBTF, being too interconnected, or being systematically important to the economy could add significant value to banking firms. Since there has never been an official published list or definition of TBTF banking organizations, the value of potential TBTF benefits is determined by the market’s perception. Using data from the merger boom of 1991-2004, this paper attempts to examine the market’s perception of the TBTF thresholds and the potential value of subsidies provided to TBTF banking institutions.

Our empirical results are consistent with the hypothesis that large banking organizations obtain advantages not available to other organizations. These advantages may include becoming TBTF and thus gaining favor with uninsured bank creditors and other market participants, operating with lower regulatory costs, and increasing the organization’s chances of receiving regulatory forbearance. We find that banking organizations are willing to pay an added premium for mergers that will put them over a TBTF threshold. This added premium amounted to an estimated $14 billion to $17 billion extra that eight banking organizations in our data set were willing to pay for acquisitions that enabled them to become TBTF (crossing the $100 billion book value of total assets threshold).

While these amounts are large, they are likely to underestimate the total value of the benefits that accrue to large banking organizations. Organizations seeking to obtain TBTF benefits are not likely to be forced by the marketplace to pass on anywhere near the full value of these benefits to the shareholders of their acquisition targets. In addition, these estimated benefits apply only to the organizations that became TBTF during our study period. Benefits already obtained by banking organizations that became TBTF prior to our sample period thus would not be included in our TBTF benefit calculations. As a result, the total subsidy value to TBTF banking organizations could easily be much higher than what we estimate.

These estimates provide an aggregate measure of the benefits accruing to large banking organizations from exceeding a TBTF threshold and do not indicate the relative contribution of any particular regulatory advantage or individual policy. By themselves, our results do not point out which particular policy directions would be most effective in addressing the benefits that large banking organizations may obtain once they become TBTF. However, our estimates of the benefits from exceeding a TBTF threshold appear large enough to cause increasing concerns as the megamerger trend continues in the U.S. banking industry. These trends could hinder the efficient allocation of financial resources across different sizes of institutions and, in turn, their customers and the overall macro-economy.

Should these TBTF banking institutions be required to pay for the privilege? If so, should they be required to hold more capital (and contingent capital that would be converted to equity capital when needed) and/or be assessed higher FDIC insurance premiums than other banks? Since these payments could not be assessed to TBTF and systemically important banking organizations under the current regime of constructive ambiguity, should the TBTF list be made publicly available? Should systemically important nonbank organizations also be assessed similar payments? These are policy questions for further research. Our findings lead us to be concerned and cautious as the number of assisted mergers between weak TBTF financial institutions continues to grow through the financial crisis that started in mid-2007, resulting in TBTF banking organizations becoming even bigger than before the beginning of the crisis. Furthermore, a few of the recent assisted mergers were between TBTF banks and nonbank financial institutions, thus extending the federal safety net related to TBTF to cover those outside the commercial banking system.

The full paper is available for download here.