Although not news to progressive critics of Wall Street, the Federal Reserve Bank of New York revealed research Tuesday that underscores why "too-big-to-fail" banks are bad for the economy.
A study focusing on the five largest banks—JPMorgan Chase, Citigroup, Bank of America, Wells Fargo and Goldman Sachs—found that these firms benefit from significant discounts on bond issues due to an assumption on the part of investors of government bailout protection.
"Remember all that talk about 'too-big-to-fail' banks having an implicit government subsidy?" writes financial reporter Danielle Douglas. "Well, this study confirms the existence of the subsidy."
Data on domestic bond issues over the 1985-2009 period reveals that, on average, big banks paid almost one third of a percentage point less than smaller banks, adding up to an average discount of $3 million for each bond issue.
Further, the study also compares these "too-big-to-fail" banks with comparable nonbank firms and found that, even in those match-ups, big banks benefit from a discount advantage. As João A. C. Santos, study author and vice president of the New York Fed's Research and Statistics Group, explains, these findings suggest that investors are willing to provide these discounts because they "view the largest banks as being more likely to be rescued if they get into financial difficulties."
If investors believe certain banks are too big to fail, they’ll discount risk when providing them with funding, therefore encouraging these banks to take greater risks. Additionally, lower financing costs will induce large banks to behave more aggressively, decreasing charter values for competing banks and pushing them toward higher risk taking.
"Even the pro-megabank New York Federal Reserve has finally acknowledged what most research has already demonstrated—the megabanks receive much more favorable borrowing terms," Senator David Vitter (R-La.) told the Washington Post. Last year, Vitter, along with Sen. Sherrod Brown (D-Ohio), introduced legislation aimed to curb these "too-big-to-fail" institutions.
"To add insult to injury, American taxpayers are funding these advantages after many of their megabanks put our economy on the brink of collapse more than five years ago," Brown added.