NY Fed Confirms Big-Bank Funding Advantage – and Link to Risky Behavior

New research from the Federal Reserve Bank of New York finds that the largest global banks – those perceived as being ”too big to fail” – enjoy a funding advantage that allows them to get loans more cheaply than their smaller competitors. Even more disturbing, this advantage seems to lead them to engage in more risky behavior, as measured by impaired and charged off loans.

In “Evidence From The Bond Markets On Banks Too Big to Fail Subsidy,” economist Joao Santos confirms that at least through 2009, the largest banks were able to borrow in the bond market at rates up to 80 basis points (eight-tenths of a percentage point) lower than smaller competitors. As analysts at Bloomberg View pointed out, this could translate to over $80 billion a year in lowered costs for the biggest banks.

Some have challenged these findings, by claiming that large non-financial firms also have lower borrowing costs than smaller firms; in other words, the argument goes, the funding advantage is not due to the ”too big to fail” perception of potential government support. But Santos’ research finds that large banks have a borrowing-cost advantage significantly greater than any advantage of large firms in other industries. As he states, his results “suggest that the cost advantage that the largest banks enjoy in the bond market relative to their smaller peers is unique to banks.”

In further research, Santos and coauthors Garo Afonso and James Traina find that the perception of ”too big to fail” status and an accompanying potential for government support appears to lead banks to engage in more risky behavior. Banks classified by ratings agencies as likely to receive government support have greater loan losses and a higher percentage of impaired loans, the paper finds, than do institutions that are not so classified. This suggests that banks take advantage of the implicit expectation of taxpayer support in the event of losses by pursuing higher profits through riskier lending. The possibility that losses from these loans could be transferred to the public leads to riskier bank behavior.