Cheat Sheet: How GAO Big Bank Subsidy Investigation Will Reignite TBTF Debate

WASHINGTON — The Government Accountability Office is poised this fall to unveil the first of two reports on whether big banks benefit from an implicit subsidy due to the perception that they are "too big to fail," adding more fuel to an already contentious debate.

The new research will arrive on the heels of numerous academic and industry studies already released, with more likely on the way. At issue is the question of whether large institutions get tangible benefits, including a lower cost of funding, because the market believes regulators would prevent them from failing.

Following are some frequently asked questions about the state of the "too big to fail" subsidy debate and the potential impact of the upcoming GAO report.

How did the GAO study come about?
The government watchdog agreed in January to look at the "economic benefit" big banks receive due to actual or perceived government support, following a request by two vocal lawmakers on the issue, Sens. David Vitter, R-La., and Sherrod Brown, D-Ohio.

The Senate passed legislation in December sponsored by the unlikely political duo that would require the GAO to examine the issue. Though the House never took a vote on the bill, the agency agreed several weeks later to take up the request.

What's the study going to look at?
The report will come in two parts, and much of what it contains is still unknown. GAO spokesman Charles Young confirmed earlier this week that the first report will be released in the fall, with the second coming out sometime in 2014. He declined to provide further detail about the content of GAO's work to date.

"As part of our review we will look at government support and economic benefits that banks and bank holding companies received from emergency government actions during the crisis, how recent financial reforms changed government safety nets for banks and bank holding companies, and factors that could impact the effectiveness of these changes," he said.

Jaret Seiberg, an analyst at Guggenheim Securities, wrote in a note to clients this week that the fall report will tabulate all of the benefits banks received from government programs during the financial crisis, including the Federal Reserve's term asset-backed loan facility and term auction facility, along with the Federal Deposit Insurance Corporation's temporary liquidity guarantee program, among others.

"Our expectation is the cost of this funding will be compared against what it would have cost for banks to get the same deals without government support," Seiberg said in the note. "As part of this involved a period where GE had to pay 10% for funding, we would expect this subsidy to be massive. Of course, it is not really a subsidy and the government actually made money on these programs. Yet for political purposes, that context will be lost. This will become a subsidy and we would expect lots of rhetoric about how taxpayers were the losers because banks got all this cheap cash."

He added: "That this is over-simplistic is irrelevant. It will create more pressure to go after the mega banks."

Two others familiar with the GAO's efforts said the second report is likely to come out in the first quarter of 2014 and will be more focused on quantifying any existing "too big to fail" subsidy.

Does a subsidy still exist?
The debate remains sharply divided as researchers devise new models and datasets for exploring the question.

"If we were engineers, I wouldn't say we have enough analysis and data to build a bridge," said Lawrence Baxter, a professor at Duke University Law School. "Now, public policy is different than a bridge, but I feel like we don't know where to put the anchors and the struts of the bridge. I don't get the feeling we've got anything like the level of science there yet that allows us to make coherent public policy."

Others question whether there exists a reliable method for determining the size of any subsidy — even those that believe the subsidy is real. Basic questions remain about what benefits should be considered and where the analysis should begin.

"The problem with all of these empirical comparisons is that you're looking at different animals. The business model of the very largest banks is different than the business model of the smallest banks," said Marcus Stanley, policy director at Americans for Financial Reform. "Say you see that borrowing costs are the same as borrowing costs at mid-sized regionals that are probably seen as not needing 'too big to fail' protection — does that mean the largest banks don't have 'too big to fail' protection? No, you have to ask what the borrowing rate would be if they were taking the same risks. A lot of these studies implicitly assume that the large and small banks are taking the same risks."

Still, many said they were hopeful about the additional attention the issue has been attracting in recent months.

"You're never going to get to the exact number, but to me the good thing is the policy debate has been moved from an exclusive focus on capital — the policy needle seems to be shifting towards saying, 'ok we do need capital requirements, but there's also this other thing, the subsidy that most people think is very large," said Cornelius Hurley, director of the Boston University Center for Finance, Law & Policy, who has devised a plan requiring banks and other large financial institutions to set aside reserves to match the market advantages they receive.

"The big banks have commissioned their own studies and they say no there is no subsidy, but at least we're talking about it now, whereas a few months ago we weren't even talking about the subsidy, other than some obscure academic papers."

What do published studies find?
A key turning point in the debate came earlier this year, when a Bloomberg editorial attempted to put an explicit price tag on the subsidy, pegging it at $83 billion a year. The report was based on earlier research by the International Monetary Fund looking at the funding costs of large institutions, and has since been cited numerous times by lawmakers, regulators and advocates.

"That was the flash point — politicians could get their hands around a number," said Baxter.

That helped spark more interest in numerous other estimates that have also contributed to the growing body of research on the issue.

For example, FDIC Vice Chairman Thomas Hoenig reviewed the available literature this summer for a hearing before the House Financial Services Committee. Hoenig, who has been outspoken about his concerns over "too big to fail," pointed to 13 studies conducted in recent years, most of which suggest a subsidy worth billions. The research review included studies that use bond prices, credit ratings, put options and other measures to estimate the size of the subsidy for banks in the U.S., U.K. and elsewhere, with data going back more than two decades in some cases.

"While the estimated size of the subsidy may vary in degree, depending on the methodology, nearly all independent studies calculate the value to be in the billions of dollars," Hoenig said in prepared testimony for the June 26 hearing. "This government subsidy facilitates these firms' growth beyond what economies of size and scope can otherwise justify and subjects the broader economy to the adverse effects of management misjudgments, which in turn entrenches the behavior of repeated financial bailouts within modern economies."

Does the banking industry agree?
Those representing the biggest banks have been quick to criticize the existing academic research, citing various concerns with the data and methodology of the work.

"It's extremely complicated to reach a definitive conclusion, because there are so many variables and explanations for funding cost differentials [among banks] other than a too-big-to-fail 'subsidy,'" said Paul Saltzman, president of the Clearing House Association, a trade group for some of the largest U.S. banks.

A key issue of contention is the timing of the data used in many of the existing studies, which often look at the funding advantage for large banks before and during the crisis.

"Given the massive changes in the regulatory environment, this seems like an odd interrogation of ancient history," said Steve Strongin, head of global investment research at Goldman Sachs, of some of the older studies.

Indeed, critics argue that the Dodd-Frank Act has made meaningful changes to the process for winding down large institutions in the event of a crisis. As a result, big banks no longer receive a subsidy, they claim.

"Funding costs [among banks] are ultimately a function of counterparty and investor perceptions, and the empirical data suggests that the post-Dodd-Frank framework is eliminating misperceptions and increasing market discipline," Saltzman said.

Strongin, who is co-author of a recent study that finds big banks in 2011 and 2012 actually paid a funding penalty, adds that many existing reports often fail to isolate the data to large U.S. banks, including either non-bank financial firms or international banks, depending on the dataset used. Detractors also argue that big banks have reported funding advantages because their bonds and other financial products are more liquid (the so-called "liquidity premium") and because they tend to rely more heavily on wholesale funding, not because of any market perceptions about how likely they are to fail.

Still, observers on both sides of the debate agreed that the surge of "too big to fail" studies is likely to continue even after the GAO finishes its work.

"I keep hearing of more [studies being conducted] every other day it seems," said Hurley. "There's a lot of attention being paid to this."

Have lawmakers attempted to address this issue?
Lawmakers in the House and Senate have raised the issue at multiple banking panel hearings over the past year, with several bills emerging in the two chambers.

Brown and Vitter introduced a bill in April that would significantly raise capital requirements for the largest banks. In July, Sens. Elizabeth Warren, D-Mass., John McCain, R-Ariz., and others unveiled a bill to bring back a Depression-era law that would separate traditional banking activities from riskier businesses like investment banking and swaps trading. Rep. Mike Capuano, D-Mass., also recently introduced a bill based on Hurley's plan requiring systemically important institutions to hold reserves equal to the market advantages they receive.

The bills are unlikely to gain much traction in the short term, but could easily return to the spotlight in the wake of the next banking crisis, be it a widespread problem like the subprime mortgage meltdown or a more isolated incident, like JPMorgan's "London Whale" scandal. That's precisely why the debate remains so hot — it's not just an academic puzzle to be solved, but an ongoing issue that has the power to shape and fundamentally alter the functioning of financial markets going forward.