STOCK MARKET WATCH -- Friday, 1 August 2014

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23. Banks Aren't Too Big to Fail Unless They Fail

http://www.bloombergview.com/articles/2014-07-31/banks-aren-t-too-big-to-fail-unless-they-fail

Here's the Government Accountability Office announcement and study on whether there's a too-big-to-fail subsidy for big banks. The answer is no-ish but it's complicated. It's complicated in part by the fact that the GAO ran 42 different regression models, and they all got different answers:

All 42 models found that larger bank holding companies had lower bond funding costs than smaller ones in 2008 and 2009, while more than half of the models found that larger bank holding companies had higher bond funding costs than smaller ones in 2011 through 2013, given the average level of credit risk each year (see figure). However, the models' comparisons of bond funding costs for bank holding companies of different sizes varied depending on the level of credit risk. For example, in hypothetical scenarios where levels of credit risk in every year from 2010 to 2013 are assumed to be as high as they were during the financial crisis, GAO's analysis suggests that large bank holding companies might have had lower funding costs than smaller ones in recent years. However, reforms in the Dodd-Frank Wall Street Reform and Consumer Protection Act, such as enhanced standards for capital and liquidity, could enhance the stability of the financial system and make such a credit risk scenario less likely.
I think you need a model for these models.1 One simple model is that the too-big-to-fail subsidy -- meaning the amount of money that big banks save on funding costs because their creditors assume that if anything goes wrong the government will bail them out -- is like a put option, putting some floor on the value of a bank's assets.2 When the put option is at-the-money -- when things are bad and the bank looks like it might default without government support -- then it's worth a lot. When the put option is out of the money -- when things are good and the bank is fine on its own -- then it's worth less.

So now it's worth less than it was worth in 2008, or in a hypothetical 2013 with 2008's credit conditions (what?). In fact, it has negative value, which is weird in a put option, but not that weird in life. It's like insurance: You pay a premium every month, and it pays off when things go bad. Some months the premium is worth more than the insurance, in expectation, and some months it's worth less. That's how insurance works: It looks like a bad deal in good times, but a good deal in bad times.