The General Accountability Office will shortly turn to the financial-policy equivalent of “When did you stop beating your wife” – when did big banks stop being too big to fail? Although the industry fought hard to block the GAO study, the Senate unanimously demanded it last Friday. The House demurred, but we think GAO will still take up the charge. When it does, it will be forced to decide if past perceptions forged by TBTF rescues have been altered by new law and rule that, while they flatly ban TBTF, have yet to be built out or crash-tested. My guess is that the GAO study design will look at market indicators still premised on TBTF, conclude that Dodd-Frank didn’t do diddly and, thereby, set back the course of market reform.
What’s the analytical problem confronting GAO? As requested by Sens. Brown and Vitter, they are to look at ratings and cost-of-funds indicators to determine the degree to which markets now exert discipline on the very largest BHCs. Last fall, FedFin released a hard look at the Dodd-Frank orderly-liquidation authority (OLA) regime to see if it in fact reverses TBTF. The study was funded by the Securities Industry and Financial Markets Association, but reflects our views, not to mention a fair amount of hard work. Included in it was a thorough data search for the stats GAO is now charged to find.
We came up empty. Anecdotal data showed a change in policy by the rating agencies, which have begun to redo their models for the biggest BHCs in expectation that the rescue cookie jar won’t be passed around anymore. However, the noise in the data made it hard for us to differentiate the ratings reductions for big BHCs that resulted from changed agency expectations from all the earnings pressures, operational losses and other bad news that has whacked big-bank earnings so hard for so long. The only good data we found – unfortunately after we finished the study – is a Federal Reserve Bank of New York analysis of credit-default swap spreads that shows growing market awareness of the new, tough stand OLA requires of U.S. regulators. Nice, I think, but far from dispositive.
Maybe the GAO will find a way to parse the ratings to track a specific causal relationship between OLA and all the post-crisis downgrades. And, maybe, GAO will also be able to dampen the noise in the funding data to figure out if the biggest BHCs have lower funding costs than small banks because they are still TBTF or, as I suspect, because current interest-rate conditions are so anomalous and big banks use capital markets so efficiently. Case in point: big banks have lost more TAG deposits than small banks, but TBTF has nothing to do with this because the FDIC – the most TBTF institution of them all – has provided an unlimited guarantee against these funds. The biggest banks hold lots of TAG deposits – reducing their funding costs – not because of TBTF, but rather because the large customers that want risk-free millions tend to be their customers, not those of the smaller community banks. These banks to be sure loved TAG a lot, but the benefit they saw in the program doesn’t obviate the data distortions TAG creates when one tries to track TBTF through funding-cost models.
Even if GAO does its darnedest with current data, it could very well conclude that big BHCs get top ratings – at least compared to small competitors – and have funding advantages. From this, it may conclude that TBTF is as before. I think this is true to some degree with regard to qualified financial contracts – a critical unfinished part of OLA – but otherwise no longer the case in law – read Title II – or, soon, in fact. The single-point-of-entry resolution regime announced last month by the FDIC is missing some key operational details, but it’s still a major step forward in making Title II not just a demand, but a practical reality.
Unsurprisingly, GAO wasn’t asked to look at these emerging cures to TBTF, just at the data to date that won’t, I expect, show the changes to come. If GAO thus concludes that TBTF remains, this will surely exacerbate risky incentives resulting from undiminished expectations that big U.S. BHCs are too big to fail. These will again lead investors to abandon caution even as the FDIC now is forced to throw them largely to the wolves in a crisis. If self-discipline is undermined by popular perception and the law stays as is, systemic risk will be at least as bad as it was in 2008 because market participants won’t be prudent and, this time, regulators can’t bail them out. If GAO can find the data to forecast how OLA will work when fully built out, more power to them. If not, the conflict between market perception and U.S. legal reality will just get worse and its potential cost to financial stability rise still higher.