Supersize Them? Large Banks, Taxpayers and the Subsidies

In the paper Supersize Them? Large Banks, Taxpayers and the Subsidies that Lay Between, I provide an in-depth study of the substantial, non-transparent governmental subsidies received by the biggest banks. Though some continue to deny the existence of these subsidies, I conclude that the subsidies exist and negatively impact the financial markets. The most significant implicit subsidy stems from market perception that the government will not allow the biggest banks to fail—i.e., that they are “too-big-to-fail” (TBTF)—enabling them to borrow at lower interest rates. I outline the solutions that have been proposed and/or implemented as an attempt to solve the TBTF problem, and I suggest a new user-fees framework that can be used in conjunction with other approaches to mitigate the consequences of the TBTF subsidies.

TBTF bank subsidies recently have drawn significant media and governmental attention. For example, in 2013 media reports sent shockwaves across financial markets by estimating that the value of the combined financial advantages and subsidies for the six biggest U.S. banks since the start of 2009 was at least $102 billion. Follow-up reports estimated that two of the biggest U.S. banks—BofA and Citigroup—were dependent on governmental backstops, as their profits would have been negative if not for the government subsidies. Likewise, another study demonstrated that the subsidies received by the largest U.S. banks were roughly equivalent to those banks’ total profits over the four quarters prior to June 2012. The subsidies issue has now taken center stage: on March 25, 2014, the NY Federal Reserve released a report describing the highly controversial megabank subsidies, and concluded that such subsidies exist.

But not everyone agrees that TBTF subsidies exist. Certain commentators argue that large banks create benefits for businesses that would not be available elsewhere. According to such commentators, the banking field facilitates substantial scale economies, which make the TBTF banks a source of gains for society. Put differently, megabanks argue that they leverage revenue and cost synergies through economies of scale, and create benefits that are passed on to their customers and investors, and lower the costs of finance for everyone. In addition, megabanks have been compiling an arsenal of studies arguing that recent regulation has reduced their advantage as “systemically important” fiscal institutions. Specifically, JPMorgan and Goldman-Sachs have released reports that argue that any cost advantage they had during the 2008 crisis has shrunk with the passage of the Dodd-Frank Act.

The Dodd-Frank Act attempts to stop TBTF benefits by: (i) forcing systemically important financial institutions (SIFIs) to internalize the costs and risks of their activities; and (ii) prohibiting the Federal Reserve from making extraordinary loans to them. But the Dodd-Frank Act has not yet offered a real solution to end the problem; for example, it does not prohibit the government from giving financial support framed in a more general fashion. As a result, government implicit and explicit subsidies and transfers from taxpayers to the biggest banks’ shareholders continue.

Traditional analysis of direct transfer subsidies is insufficient to determine whether or not the TBTF subsidies exist. First, the data on TBTF subsidies is fragmented, making it extremely difficult to calculate the subsidies’ total value. Second, there are many ways for politicians to give less-visible financial benefits. Moreover, a large number of the non-cash political interventions are difficult to quantify because they involve many government programs spanning different agencies.

Focusing on the financial sector as an example, the TBTF subsidies have had several perverse effects. First, the government’s support to the biggest banks can be viewed as an unfair competitive advantage over smaller banks, which hurts the economy and has caused many small banks’ failures especially since 2008. Despite having a fairly cheap source of capital due to deposit insurance, small banks still are disfavored because they must fully pay for that insurance. On the other hand, the biggest banks hold different types of assets, many of which historically did not require deposit insurance payment; they also enjoy the benefits of market perception that the government will not let them fail. Second, the grant of TBTF subsidies may impact the delicate and balanced separation of powers firmly mandated by our founding fathers, because Congress’ power to provide subsidies is being used and not monitored, and taxpayers don’t have standing to challenge the subsidies in court. Third, the financial benefits of the TBTF subsidies arguably permit otherwise unsuccessful TBTF banks to grow to size where they become “too-big-to-jail”—a semi-immunity policy that de facto exempts the biggest banks from criminal statutes. Fourth, the subsidies may change the biggest banks’ behavior by incentivizing them to borrow more, to take more excessive risks, and even to break the law (if the entities become “too-big-to-jail”). The subsidies disincentivize bank executives from properly evaluating the quality of their bank’s business model, its management, and its risk-taking behavior. As a result, such banks face limited market discipline, enabling them to gain more funding on better terms than the quality or riskiness of their business would merit, and incentivizing them to take excessive risks.

The paper commences by discussing the concept of subsidies, describing the different estimates of the subsidies, and analyzing the reliability of various TBTF subsidy studies. The article then explores the perverse effects that result from granting subsidies to megabanks. The article then outlines the solutions that have been suggested thus far: (i) increasing capital and liquidity requirements for banks; (ii) shifting the focus to the creditors of megabanks, to make the creditors take losses when the banks run into trouble; (iii) setting activities and size restrictions; (iv) reducing the economy’s exposure, following the Dallas Fed Plan; and (v) setting aside reserves equal to the net advantage that the large banks get for being SIFIs. Finally, the article suggests incorporating a new solution—a user-fees mechanism—which could be used together with other approaches to help address the problem, and would not require big banks to pay anything if they really do not benefit from such subsidies.

The full paper is available for download here.