Surprise, Surprise: TBTF Problem Remains

Sometimes it feels like I've seen it all. After 10 years of representing community banks in the nation's capital, it takes a lot to surprise me.

But I must admit I was pleasantly stunned when Wall Street's financial regulator recently released reports concluding the largest banks enjoy a cost advantage consistent with the idea that they are "too big to fail." Why the shock? Because the series of reports came from economists at the Federal Reserve Bank of New York, often seen as the regulator coziest with the Wall Street megabanks it regulates.

The studies look wide and deep into the taxpayer-based subsidy that we at the Independent Community Bankers of America have long maintained "too big to fail" banks enjoy. The results aren't pretty for anyone interested in open markets and financial security, but they offer an important look at this persistent and burgeoning problem.

For one, the studies offer further evidence of the megabank cost advantage that many researchers have already identified. According to economist João Santos, bond spreads at the largest banks were an average of 41 basis points lower than those of smaller banks through 2009, controlling for bond characteristics. This suggests investors believe the largest banks are likely to be classified as "too big to fail" and to be rescued if they run into financial trouble, which allows the largest banks to access funding more cheaply than their smaller competitors.

In a separate report, economists asked whether "too big to fail" banks take on more risk than other institutions. The answer, unsurprisingly, is yes. According to the report, the largest banks have a greater appetite for risk if they expect future rescues, and banks that are more likely to receive government bailouts engage in more risk-taking. In other words, risk leads to bailouts, and bailouts lead to risk.

The reports conclude with some thoughtful recommendations on what we can do to try to stop this cycle of doom. The final paper in the series advocates requiring systemically risky bank holding companies to issue long-term debt that converts to equity once a large failed bank is in resolution. This debt would substitute uninsured financial liabilities, not equity capital, and would help offset the cost and instability of large bank failures. While the authors warn this is not a panacea and would not prevent the buildup of systemic risk, the proposal would clearly help prepare megabanks for the possibility of failure, getting taxpayers off the hook and reducing the "too big to fail" market perception.

Following the release of the New York Fed reports, the International Monetary Fund released a separate study estimating the 2012 value of the "too big to fail" subsidy at up to $70 billion in the U.S. and up to $300 billion in the euro area. In its study, the IMF said the "too big to fail" issue has intensified in the wake of the 2008-09 financial crisis because the crisis left little uncertainty about the willingness of governments to support big banks in distress and because banks have continued to grow bigger in a consolidating industry.

In short, "too big to fail" is real, tangibly benefits the biggest banks, distorts free markets, incentivizes risky behavior, puts our financial system in jeopardy, has strengthened following recent government bailouts and requires additional megabank capital as an offset. Gee, where have I heard that line before? Oh yeah, ICBA and community bankers have been saying that for years.

Community bankers know full well they face a government-sourced competitive disadvantage because they have to operate their businesses under these conditions every day. We watched firsthand as mammoth financial firms received hundreds of billions of dollars in direct taxpayer funding and government loans following a financial crisis that they themselves caused. We've fought hard to stay afloat and to continue serving our communities, all the while paddling upstream against this subsidy.

Let me be clear, I'm not shocked by these results. But I am surprised that the truth was set free in an encyclopedic volume of 11 reports from the New York Fed and a follow-up report from the IMF confirming prior research on the subject. I applaud these institutions' fortitude in the face of what must have been significant headwinds.

ICBA and community bankers have known the truth of "too big to fail" all too well for way too long. We have suffered the consequences through massive consolidation and concentration in our financial system. The largest and most powerful arm of the central bank of the U.S. has finally admitted the megabank emperors have no clothes. It is past time that we as a nation get to the bottom of this dangerous threat and fix it before it takes our economy down again. I sincerely hope that our policymakers are ready, because time is running out.

Camden R. Fine is president and CEO of the Independent Community Bankers of America.