James J. McAndrews and Donald P. Morgan
This post is the thirteenth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
The motivation for the Economic Policy Review series was to understand better the behavior of large and complex banks, and we have covered a lot of ground toward that end. We have examined large banks’ economies of scale, their proclivity toward risk taking, their possible funding advantages (pre-Dodd Frank), the sources and types of their complexity, and the sources and means of dealer bank financing. We have also looked at resolution issues surrounding large and complex banks, including a case study on the Lehman bankruptcy, a review of resolution methods, and two studies of the rationale for a long-term debt requirement for large and complex banks (bail-in), which could provide a source of loss absorbency in resolution. In this post, we provide our own thoughts on what the series has taught us.
On Bank Size and Complexity
As noted in the introduction to the series, big banks have been viewed by critics with a distinctly suspicious eye. However, some of our findings show that there may be good, or at least benign, reasons for the existence of large banks. The first article in the series finds that large banks have significantly lower operating costs, a finding that is consistent with the “new economies of scale” literature (see Hughes and Mester and references therein) in banking. That implies that breaking up big banks is not a free lunch. Indeed, the article estimates that limiting bank assets to 4 percent of GDP (about $625 billion), as has been advocated, would raise industry operating costs by $2 billion to $4 billion dollars per quarter. Presumably, the increase in operating costs associated with a size cap would be passed on to bank customers in the form of lower deposit rates, higher loan rates, or worse services.
That is not to say that all of our findings on size were favorable toward big banks. This article found that large banks had a funding advantage relative to smaller banks. However, it’s important to note (as the author did) that the data sample ended before passage of the Dodd-Frank Act; the resolution reforms in that act were designed to ameliorate the “too-big-and-complex-to-fail” (TBTF) problem. This article found that an increase in the likelihood that a bank receives government support (as captured by rating agencies) results in an increase in its impaired loans ratio. However, the article also found that an increase in the probability of government support translates into an increase in the bank’s Tier 1 capital ratio.
Critics have also looked suspiciously at big bank complexity, in some cases without being explicit about what they mean by complexity. Our initiative shed light at that fundamental level with two articles that defined and delineated different dimensions of bank complexity and then measured them accordingly. This article documents how banks have evolved from relatively simple commercial banks to more organizationally complex bank holding companies with subsidiaries engaged in a wide variety of financial (nonbank) activities. The article advances the hypothesis that this increase in organizational complexity may mirror the evolution of the “technology” of financial intermediation, as reflected, for example, by an extended “credit intermediation chain” centered around the securitization process. That article also showed that organizational complexity occurred throughout the financial industry, and was not confined to banks, indicating that it was unlikely to be a response to banking regulations or changes in banking regulation. Another article on complexity showed that some forms of complexity, namely geographic complexity and business complexity (the number of lines of business), are not highly correlated with bank size, suggesting that those forms of complexity won’t necessarily be reduced if bank size is capped. While these articles make strides in measuring complexity and its possible motivations, the case study on the Lehman bankruptcy shows us that more work is needed to address related issues: other drivers of complexity, the impact of complexity on resolution, bank opacity, and the difficulties in managing complex banks.
Complexity can hide risks in plain sight, as the authors of this article on the funding complexity of dealer banks showed. During the crisis, dealer banks were financing about $4 trillion in loans, but because of liberal netting rules, were reporting 30 percent less than that on their balance sheets. As a result, the banks held less capital and liquidity than would have been prudent given their exposures to risky loans. Furthermore, when the crisis came, dealers’ off-balance sheet exposures contracted far more than their balance sheet exposures, indicating just how fragile and risky those exposures were. The accounting netting rules employed by those banks do not reflect true economic netting of risks. Banks should not adopt approaches to measurement and management of risks that won’t withstand stress, and supervisors are working to ensure that banks measure and manage those risks appropriately.
Bail-in, Bail-in, Bail-in
We strongly second the conclusions of this article and this article that supported a bail-in-able long-term debt requirement for large and complex banks. Of course, bail-in has been already been widely endorsed; indeed, it is considered a key attribute of effective resolution regimes for financial institutions by the Financial Stability Board. However, our research added value by providing more conceptual footing for bail-in policies.
One question the series did not take up is how much bail-in-able debt would cost the issuers—that is, what spread investors would demand to buy such an instrument. It would be premature to try and put a precise number on that now, but we can make some general points. Clearly, long-term debt that is bail-in-able (that is, subordinate to uninsured financial liabilities such as uninsured deposits, repo, derivative liabilities, and commercial paper) would be costlier, all else equal, than long-term debt that is on equal footing with those liabilities. However there are several mitigating effects that would limit the extra cost of issuing bail-in-able debt. First, the bail-in-able debt would have the benefit of preventing runs by uninsured financial liability holders, making the bail-in-able debt safer compared with a regime without bail-in-able debt. Second, by making uninsured financial liabilities safer in resolution, a bail-in-able debt requirement would lower the cost of issuing uninsured financial liabilities. Third, although bail-in-able debt likely would be more expensive to the issuer than ordinary debt (all else equal), it would still be cheaper than equity, and would have important social benefits of reducing the likelihood of a messy failure.
Restructure Bank Liabilities, Not Banks
Taken together, our findings suggest that a sound approach to the TBTF problem is not to restructure banks, but to restructure their liabilities. Shrinking big banks is not necessarily a panacea if banks continue to rely on runnable uninsured financial liabilities and thus remain subject to messy failures. After all, even if large TBTF banks were “broken up,” into smaller banks the size of Lehman Brothers (roughly 4 percent of GDP, the limit on bank size that has been proposed), they would still create messy failures, because of the reliance on uninsured financial liabilities.
Unlike equity, debt is a hard claim—so with large amounts of bail-in-able debt, we would expect that a bank resolution would likely be triggered when banks can’t roll it over; but that is far better than a bank run by uninsured financial liability holders triggering the resolution (because the amount of long-term debt that rolls over each period is less than the amount of uninsured financial liabilities that are runnable). The presence of the bail-in-able debt won’t eliminate the risk of failure, but it can reduce the likelihood of runs by uninsured financial liability holders, thus resulting in less messy failures.
Another point on the “hard claim” nature of debt: as a bank with large amounts of bail-in-able debt loses value, it will quickly be subject to a debt overhang problem. To issue more debt, it would either have to pay extraordinarily high rates of interest on the new debt, or raise equity. Those dynamics, although potentially difficult and destabilizing for the bank, force the bank and the resolution authority to address losses much earlier than would otherwise be the case. Thus, this policy might well result in more frequent resolutions of large banks.
Our findings suggest that breaking up large and complex banks may not be the best course of action to deal with the TBTF problem; in fact, they suggest that there are efficiency costs associated with doing so that must be traded off against any potential benefits. Our findings also suggest, through our measurement of the increased complexity of banks, the need for a macro- and micro-prudential supervisory framework that is equipped to deal with large and complex banks. And of course, through the Dodd-Frank Act, the Financial Stability Board initiatives, and the Basel III agreements, the framework for monitoring and regulating financial intermediaries is currently undergoing significant revision both domestically and internationally. In our view, we should continue to implement these reforms, including the Title II orderly liquidation authority reform and the FDIC’s related single point of entry plan, and, importantly, to support those reforms with a strong, long-term, bail-in debt requirement to address the TBTF problem.
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.
James J. McAndrews is an executive vice president and the director of research at the Federal Reserve Bank of New York.
Donald P. Morgan is an assistant vice president in the Bank’s Research and Statistics Group.