Large Bank Holding Companies: Expectations of Government Support
Published: 2014-07-31T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: “Too big to fail” is a market notion that the federal government would intervene to prevent the failure of a large, complex financial institution to avoid destabilizing the financial sector and the economy. Expectations of government rescues can distort investor incentives to properly price the risks of firms they view as too big to fail, potentially giving rise to funding and other advantages for these firms.
GAO was asked to review the benefits that the largest bank holding companies (those with more than $500 billion in assets) have received from perceived government support. This is the second of two GAO reports on government support for bank holding companies. The first study focused on actual government support during the 2007-2009 financial crisis and recent statutory and regulatory changes related to government support for these firms. This report examines how financial reforms have altered market expectations of government rescues and the existence or size of funding advantages the largest bank holding companies may have received due to perceived government support.
GAO reviewed relevant statutes and rules and interviewed regulators, rating agencies, investment firms, and corporate customers of banks. GAO also reviewed relevant studies and interviewed authors of these studies. Finally, GAO conducted quantitative analyses to assess potential “too-big-to-fail” funding cost advantages.
In its comments, the Department of the Treasury generally agreed with GAO's analysis. GAO incorporated technical comments from the financial regulators, as appropriate.
section_title: What GAO Found
paragraphs: While views varied among market participants with whom GAO spoke, many believed that recent regulatory reforms have reduced but not eliminated the likelihood the federal government would prevent the failure of one of the largest bank holding companies. Recent reforms provide regulators with new authority to resolve a large failing bank holding company in an orderly process and require the largest bank holding companies to meet stricter capital and other standards, increasing costs and reducing risks for these firms. In response to reforms, two of three major rating agencies reduced or removed the assumed government support they incorporated into some large bank holding companies' overall credit ratings. Credit rating agencies and large investors cited the new Orderly Liquidation Authority as a key factor influencing their views. While several large investors viewed the resolution process as credible, others cited potential challenges, such as the risk that multiple failures of large firms could destabilize markets. Remaining market expectations of government support can benefit large bank holding companies if they affect investors' and customers' decisions.
GAO analyzed the relationship between a bank holding company's size and its funding costs, taking into account a broad set of other factors that can influence funding costs. To inform this analysis and to understand the breadth of methodological approaches and results, GAO reviewed selected studies that estimated funding cost differences between large and small financial institutions that could be associated with the perception that some institutions are too big to fail. Studies GAO reviewed generally found that the largest financial institutions had lower funding costs during the 2007-2009 financial crisis but that the difference between the funding costs of the largest and smaller institutions has since declined. However, these empirical analyses contain a number of limitations that could reduce their validity or applicability to U.S. bank holding companies. For example, some studies used credit ratings which provide only an indirect measure of funding costs.
GAO's analysis, which addresses some limitations of these studies, suggests that large bank holding companies had lower funding costs than smaller ones during the financial crisis but provides mixed evidence of such advantages in recent years. However, most models suggest that such advantages may have declined or reversed. GAO developed a series of statistical models that estimate the relationship between bank holding companies' bond funding costs and their size or systemic importance, controlling for other drivers of bond funding costs, such as bank holding company credit risk. Key features of GAO's approach include the following:
U.S. Bank Holding Companies: The models focused on U.S. bank holding companies to better understand the relationship between funding costs and size in the context of the U.S. economic and regulatory environment.
Bond Funding Costs: The models used bond yield spreads—the difference between the yield or rate of return on a bond and the yield on a Treasury bond of comparable maturity—to measure funding costs because they are a risk-sensitive measure of what investors charge bank holding companies to borrow.
Extensive Controls : The models controlled for credit risk, bond liquidity, and other variables to account for factors other than size that could affect funding costs.
Multiple Models : GAO used 42 models for each year from 2006 through 2013 to assess the impact of using alternative measures of credit risk, bond liquidity, and size and to allow the relationship between size and bond funding costs to vary over time with changes in the economic and regulatory environment.
Credit Risk Levels : GAO compared bond funding costs for bank holding companies of different sizes at the average level of credit risk for each year, at low and high levels of credit risk for each year, and at the average level of credit risk during the financial crisis.
The figure below shows the differences between model-estimated bond funding costs for bank holding companies with $1 trillion in assets and bank holding companies with $10 billion in assets, with average levels of credit risk in each year. Circles represent statistically significant model-estimated differences.
Estimates from 42 Models of Average Bond Funding Cost Differences between Bank Holding Companies with $1 Trillion and $10 Billion in Assets, 2006-2013
Notes: GAO estimated econometric models of the relationship between BHC size and funding costs using data for U.S. BHCs and their outstanding senior unsecured bonds for the first quarter of 2006 through the fourth quarter of 2013. The models used bond yield spreads to measure funding costs and controlled for credit risk factors such as capital adequacy, asset quality, earnings, maturity mismatch, and volatility, as well as bond liquidity and other characteristics of bonds and BHCs that can affect funding costs. GAO estimated 42 models for each year from 2006 through 2013 to assess the sensitivity of estimated funding cost differences to using alternative measures of capital adequacy, volatility, bond liquidity, and size or systemic importance. GAO used the models to compare bond funding costs for BHCs of different sizes but the same levels of credit risk, bond liquidity, and other characteristics. This figure compares bond funding costs for BHCs with $1 trillion and $10 billion in assets, for each model and for each year, with average levels of credit risk. Each circle and dash shows the comparison for a different model, where circles and dashes below zero suggest BHCs with $1 trillion in assets have lower bond funding costs than BHCs with $10 billion in assets, and vice versa.
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.
This analysis builds on certain aspects of prior studies, but important limitations remain and these results should be interpreted with caution. GAO's estimates of differences in funding costs reflect a combination of several factors, including investors' beliefs about the likelihood a bank holding company will fail and the likelihood it will be rescued by the government if it fails, and cannot precisely identify the influence of each factor. In addition, these estimates may reflect factors other than investors' beliefs about the likelihood of government support and may also reflect differences in the characteristics of bank holding companies that do and do not issue bonds. Finally, GAO's estimates, like all past estimates, are not indicative of future trends.

section_title: Letter
paragraphs: “Too big to fail” refers to a market notion that the federal government  would intervene to prevent the failure of a large, interconnected financial  institution to avoid harm to the economy. Events during the 2007-2009  financial crisis heightened concerns that market participants had come to  view several of the largest U.S. financial institutions as too big to fail.  Most notably, the U.S. government intervened to provide tens of billions  of dollars of capital and other support to a few large troubled financial  institutions out of concern that allowing these firms to go into bankruptcy  would have further disrupted troubled credit markets and damaged  confidence in the U.S. financial system. Market expectations of  government rescues can distort the incentives of investors and  counterparties to properly price and restrain the risks of firms they believe  to be too big to fail, potentially giving rise to funding cost and other  advantages for these firms relative to smaller competitors. For example,  creditors may be willing to accept lower interest rates on debt issued by  these firms if they believe the possibility of a government rescue reduces  the likelihood that they could suffer losses. If creditors and other  counterparties do not fully charge a firm for the risks it is taking, that firm  may have incentives to take on greater risks in the pursuit of higher  returns. Excessive risk-taking in response to such incentives can increase  the likelihood that such a firm could become distressed and disrupt  financial markets.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank Act) prohibits rescues of individual failing financial institutions and  provides new tools and authorities for the Federal Deposit Insurance  Corporation (FDIC) to resolve a large failing financial institution in a  manner that imposes losses on the firm’s creditors and other investors  while minimizing adverse impacts to the economy. Nevertheless, market  observers have continued to debate whether some of the largest and  most complex financial institutions may continue to benefit from beliefs  among their investors and counterparties that the government might  intervene to prevent their failure.
You asked us to review any economic benefits that the largest bank  holding companies (those with more than $500 billion in total consolidated  assets) have received as a result of actual or perceived government  support. This is the second of two reports we are issuing on this topic.  In  this report, we review (1) what is known about how financial reforms have  altered market expectations of government rescues and the relative  advantages or disadvantages of being a large bank holding company and  (2) the extent to which the largest bank holding companies have received  funding cost advantages as a result of perceptions that the government  would not allow them to fail.
subsections: section_title: Scope and Methodology
paragraphs: In November 2013, we issued the first report, which examined (1) actual government  support for banks and bank holding companies during the financial crisis and (2) recent  statutory and regulatory changes related to government support for banks and bank  holding companies. See GAO, Government Support for Bank Holding Companies:  Statutory Changes to Limit Future Support Are Not Yet Fully Implemented, GAO-14-18  (Washington, D.C.: Nov. 14, 2013). At a January 2014 hearing, we provided testimony  based on this report. See GAO, Government Support for Bank Holding Companies:  Statutory Changes to Limit Future Support Are Not Yet Fully Implemented, GAO-14-174T  (Washington, D.C.: Jan. 8, 2014). holding company.these reforms from credit rating agencies, investment firms, and  corporations that are customers of banks. Where available and relevant,  we reviewed some public statements, reports, and other analyses by  these groups. For example, to obtain information about credit rating  agencies’ assessments of the likelihood and level of government support  for large bank holding companies, we reviewed relevant publications by  the three largest credit rating agencies: Fitch Ratings (Fitch), Moody’s  Investors Service (Moody’s), and Standard & Poor’s (S&P). We  interviewed representatives from each of these rating agencies to obtain  their perspectives on factors contributing to changes in their assessments  of government support over time.
We obtained perspectives on the potential impacts of  We conducted interviews with representatives from 10 investment firms  and six corporations to learn about (1) factors that influence their  decisions to invest in or do business with bank holding companies of  various sizes; (2) how they assess the risks of banks and the extent to  which they rely on credit rating agencies’ assessments of these risks; (3)  their views on the likelihood that the federal government would intervene  to prevent the failure of a large bank holding company and factors that  have influenced these views over time; and (4) how, if at all, expectations  of government support have impacted their decisions to invest in or do  business with banks of various sizes. In selecting investment firms and  large corporations for interviews, we selected nonrepresentative samples  of firms. As a result, the views we present from these firms are not  generalizable to the broader community of bank investors and customers  and do not indicate which views are most prevalent. We selected  investment firms with experience investing in debt or equity securities of  banks and bank holding companies and selected different types of  investment firms to obtain perspectives reflecting a range of investing  strategies. Specifically, we selected three large asset management firms  (each with more than $1 trillion in assets under management); three  public pension funds (each with more than $50 billion in assets under  management); three hedge funds; and one large insurance company. We  selected U.S. corporations from different industry sectors and with a  range of banking needs. We identified four of these firms and contacted  them with the assistance of the U.S. Chamber of Commerce, which  reached out to its members on our behalf, and selected two additional  firms to achieve additional diversity across industry sectors. The  corporations we interviewed included four multinational corporations (a  chemical company, a delivery and logistics company, an energy  company, and a technology company) and two corporations with all or  close to all of their operations in the United States (a regional electric  utility company and a national retail services company).
To obtain additional information and perspectives on how financial  reforms or credit ratings could impact the relative advantages or  disadvantages of being a large bank holding company, we reviewed  relevant publicly available information in the financial statements of bank  holding companies and conducted interviews with bank holding  companies of various sizes, bank industry associations, public interest  groups, academics, and other experts. For example, we reviewed bank  holding companies’ financial disclosures about how Dodd-Frank reforms  could increase certain fees and how a credit rating downgrade could  impact the amount of collateral required of them under certain financial  contracts. We also reviewed our prior work on potential impacts of Dodd- Frank Act implementation.
As part of our first objective, we reviewed regulators’ efforts to assess  their progress in addressing too-big-to-fail perceptions and market  distortions that can result. We reviewed Dodd-Frank Act provisions that  outline statutory responsibilities for the Financial Stability Oversight  Council (FSOC) and reviewed relevant sections of the FSOC annual  report. We interviewed officials from FSOC, the Department of the  Treasury (Treasury), the Board of Governors of the Federal Reserve  System (Federal Reserve Board), FDIC, and the Office of the Comptroller  of the Currency (OCC) about their efforts to analyze the impacts of Dodd- Frank reforms on too-big-to-fail perceptions and to evaluate whether  additional policy actions may be needed to address any remaining market  distortions. We also reviewed relevant congressional testimonies and  other public statements by agency officials.
To assess the extent to which the largest bank holding companies have  received funding cost advantages as a result of perceptions that the  government would not allow them to fail, we conducted an econometric  analysis of the relationship between a bank holding company’s size and  its funding costs. To inform our econometric approach and understand  the breadth of results and methodological approaches, we reviewed  studies that estimated the funding cost difference between large and  small financial institutions that could be associated with the perception  that some institutions are too big to fail. We evaluated studies that met  the following criteria: (1) used a comparative empirical approach that  attempted to account for differences across financial institutions that  could influence funding costs, (2) included U.S. bank holding companies,  and (3) included analysis of data from 2002 or later. We chose these  criteria to identify the most relevant and rigorous studies related to our  research objective. To identify studies that met these criteria, we sought  input from individuals, agencies, and groups that we interviewed,  identified studies cited in an initial set of studies we had already identified,  and conducted a systematic search of research databases (including  Google Scholar and SSRN).
Our criteria excluded studies that used option-pricing approaches—that  is, techniques that use tools for pricing stock options to estimate the value  associated with possible government interventions to assist distressed  banks—because these studies assume a too-big-to-fail funding cost  advantage exists and only estimate its magnitude. We also excluded two  studies that otherwise met our criteria, but did not attempt to control for  important differences between financial institutions. We were aware of  potential conflicts of interest associated with a number of studies in our  review. For example, one study was conducted by researchers at a large  bank holding company and two others were sponsored by a trade group  representing large commercial banks. We considered the potential impact  these conflicts of interest might have on their methods and results. We  ultimately included 16 studies in our review that we determined were  sufficiently reliable for the purposes of this report.
In reviewing these studies, we assessed what they identified as the level  of funding cost differences and how that level has changed over time and  we identified the strengths and limitations of the studies’ approaches.  Because of limitations of the methodologies of these studies, their results,  while suggestive of general trends, are not definitive and thus should be  interpreted with caution. We interviewed authors of selected studies,  federal financial regulators, and other experts to obtain perspectives on  the strengths and limitations of relevant quantitative approaches that have  been used.
Taking into consideration the strengths and limitations of different  methodologies, we developed our own econometric approach to evaluate  the extent to which the largest bank holding companies may have  received funding cost advantages as a result of perceptions that the  government would not allow them to fail. In addition, we selected three  experts with relevant expertise to review our econometric approach and  assess its strengths and limitations. These experts reviewed our  approach before we implemented it and provided comments on our  methodology. In many instances, we made changes or additions to our  models to address their comments, and in other instances, we disclosed  additional limitations of the models. Before selecting these experts, we  reviewed potential sources of conflicts of interest, and we determined that  the experts we selected did not have any material conflicts of interest for  the purpose of reviewing our work.
We used a multivariate regression model to estimate the relationship  between bank holding companies’ funding costs and their size while  controlling for factors other than size that may also influence funding  costs. Our general regression model is the following:  In this model, 𝑏 denotes the bank holding company, 𝑞 denotes the  quarter, 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑏𝑞 is the bank holding company’s cost of funding in  a quarter, 𝑠𝑖𝑧𝑒𝑏𝑞 is a measure of the bank holding company’s size at the  beginning of the quarter, 𝑐𝑟𝑒𝑑𝑖𝑡 𝑟𝑖𝑠𝑘𝑏𝑞 is a list of proxies for the bank holding company’s credit risk—the risk that the bank holding company will  not repay the funds it borrowed as agreed, 𝑋𝑏𝑞 is a list of other variables  that may influence funding costs, 𝜀𝑏𝑞 is an idiosyncratic error term, and  𝛼,𝛽,𝛾,𝛿, and Θ are parameters to be estimated. The parameter 𝛽 captures the direct relationship between a bank holding company’s  funding cost and its size. The parameter 𝛿 captures the indirect  relationship between a bank holding company’s funding cost and its size  that exists if the size of a bank holding company affects the relationship  between its funding cost and credit risk. If investors view larger bank  holding companies as less risky than smaller bank holding companies  due to beliefs that the government is more likely to rescue larger bank  holding companies in distress, then either 𝛽 is less than zero, 𝛿 is less than zero, or both. However, the parameters 𝛽 and 𝛿 may also reflect factors other than these beliefs.
We used a measure of funding costs based on bonds issued by bank  holding companies. Bank holding companies use a variety of funding  types from different sources, including various types of deposits, bonds,  and equity. We used bond yield spreads—the difference between the  yield on a bond and the yield on a Treasury bond of comparable  maturity—to measure a bank holding company’s cost of bond funding.  Treasury securities are widely viewed as a risk-free asset, so the yield  spread measures the price that investors charge a bank holding company  to borrow to compensate them for credit risk and other factors. We  focused on bond yield spreads because they are a measure of funding  costs that is available for bank holding companies of a range of sizes,  including bank holding companies with less than $10 billion in assets.  Furthermore, bonds are traded in secondary markets, so changes in bond  yield spreads can be publicly observed in a timely manner. Finally, bond  yield spreads are a direct measure of funding costs, unlike alternatives  such as credit ratings.
We used Bloomberg to identify U.S. bank holding companies with more  than $500 million in assets that were operating in 1 or more years from  2006 through 2013, and to identify all plain vanilla, fixed-rate, senior  unsecured bonds issued by these bank holding companies, excluding   We collected data on bond  bonds with an explicit government guarantee.yield spreads, bank holding company size, variables associated with bank  holding company credit risk, and bond characteristics from Bloomberg.  We used these data to assemble a dataset with one observation for each  bond in each quarter from the first quarter of 2006 through the fourth  quarter of 2013. We constructed alternative measures to control for size,  bond liquidity, and credit risk due to uncertainty about how to  appropriately capture these important factors influencing bond yields and  because the regression results may be sensitive to alternative  specifications (see table 1). The numbers of bank holding companies and  bonds we analyzed and summary statistics for our indicators of size,  credit risk, and other factors are in appendix I.
We developed a variety of econometric models that use alternative  measures of bond liquidity, bank holding company credit risk, and the size  or systemic importance of a bank holding company. We estimated the  parameters for each of our models separately for each year from 2006  through 2013 to allow the relationship between bank holding company  size and bond funding costs to vary over time. Our baseline models used  average yield spreads on senior unsecured bonds based on actual  trades, executable quotes, and composites derived from executable and  indicative quotes to measure bond funding costs; total assets to measure  size; equity capital and subordinated debt as percentages of total assets  to measure capital adequacy; and issue size and total volume to measure  bond liquidity. We estimated the baseline model for each year and for  each of our five measures of volatility, as well as for each year without a  measure of volatility. We also estimated models that added average bid- ask spread to our baseline indicators of bond liquidity, models that used  average yield spreads based only on actual trades, models that used  equity capital and subordinated debt as percentages of risk-weighted  assets as our indicators of capital adequacy, models that used global  systemically important bank (GSIB) designation as an indicator of size,  models that used the $50 billion asset threshold as an indicator of size,  and models that used both total assets and the square of total assets as  indicators of size.from 2006 through 2013. For all models, we included indicators for each  quarter to control for the influence on yield spreads of economic  conditions, the regulatory environment, and other factors that vary over  time but not across bank holding companies. The details of the models  we estimated and the results for our baseline models for select years are  in appendix I.
Altogether, we used 42 separate models for each year  We used our models to compare bond funding costs for bank holding  companies of different sizes, all else being equal. account for the possibility that investors’ beliefs about government  rescues depend on the credit risk level of the bank holding company, we  made comparisons for bank holding companies with the average level of  credit risk that prevailed each year. In addition, we assessed the impact  of credit risk on our comparisons by making comparisons at credit risk  levels higher and lower than the average for each year and also while  holding the level of credit risk constant over time at the average level for  2008—the year when the financial crisis peaked and credit risk for bank  holding companies was high. By holding credit risk constant, we can  assess the extent to which changes in average credit risk over time may  have influenced changes in funding costs relative to other factors.
Our models allow the size of a bank holding company to influence its bond funding costs  directly and also indirectly through the interactions between size and the credit risk  variables. As a result, no single parameter is sufficient to describe the relationship  between bond funding costs and size. To summarize the overall relationship between  bond funding costs and size reflected in each specification, we calculated bond funding  costs for bank holding companies of different sizes and credit risk levels using our  estimates of the parameters for each specification for each year. See appendix I for more  details on the calculations. size of the losses that the government may impose on investors if it  rescues the bank holding company, but our methodology—like the  methodologies used by other researchers—does not allow us to precisely  identify the influence of each of these components. Although we have  taken into account many factors that may influence bond yield spreads  and that differ for bank holding companies of different sizes, our  estimates of differences in bond yield spreads for bank holding  companies of different sizes may reflect factors other than investors’  beliefs about the likelihood of government support because our control  variables are imperfect or may be incomplete. In addition, our estimates  of differences in bond yield spreads for bank holding companies of  different sizes may reflect differences in the characteristics of bank  holding companies that choose to issue bonds. The section of this report  that addresses our second objective contains a fuller discussion of the  limitations associated with our empirical work.
For parts of our work that involved the analysis of computer-processed  data, such as market data used in our analysis of funding cost  differences, we assessed the reliability of these data by reviewing  relevant documentation and conducting interviews with data providers to  review steps they took to collect and ensure the reliability of the data. In  addition, we electronically tested data fields for missing values, outliers,  and obvious errors. We determined that these data were sufficiently  reliable for our purposes.
We conducted this performance audit from January 2013 to July 2014 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Background
paragraphs: While the 2007-2009 financial crisis highlighted concerns about the  market distortions that can result from too-big-to-fail perceptions, concern  about such distortions pre-dated the crisis. A key factor giving rise to the  too-big-to-fail dilemma has been the emergence of financial institutions of  such size, interconnectedness, and market importance that their failure  could threaten to severely disrupt the financial system and damage the  economy. Although the federal government’s policy responses to failing  financial institutions in recent decades have not formed a clear pattern in  terms of the availability or structure of government support, these  responses may have influenced market views on the likelihood of  government support. Several observers trace too-big-to-fail concerns  back to 1984 when FDIC provided support to Continental Illinois National  Bank, then the sixth largest U.S. bank in terms of total assets, to prevent  its failure and losses to its depositors and creditors. The Federal  Reserve Board’s response to the near failure of a large U.S. hedge fund,  Long-Term Capital Management (LTCM), in 1998 was another significant  event that may have contributed to too-big-to-fail perceptions. While  LTCM was not itself a large bank, the Federal Reserve Board’s  intervention in helping to facilitate private-sector assistance to LTCM may  have signaled the willingness of federal government authorities to  intervene to avoid potential systemic consequences from a large,  interconnected financial firm’s failure. Other factors may have contributed  to some ambiguity surrounding the likely recipients and circumstances of  government support in the years leading up to the 2007-2009 financial  crisis. For example, failures and near-failures of large financial firms had  been infrequent and occurred under varying circumstances, making it  difficult to discern a clear pattern of government support.
During the 2007-2009 crisis, the federal government took actions to  stabilize the financial system by creating new emergency programs with  broad-based eligibility and providing firm-specific assistance to prevent  the failures of large financial institutions. Notably, however, U.S. government authorities’ initial responses to impending failures of large  financial institutions did not send a clear signal about the availability of  government support. In March 2008, the Federal Reserve Board  authorized emergency assistance to prevent the failure of one large  investment bank (Bear Stearns Companies, Inc.), but 6 months later,  Federal Reserve Board officials determined that they could not assist  another large failing investment bank, Lehman Brothers Holdings, Inc.  (Lehman Brothers). Following Lehman Brothers’ bankruptcy  announcement on September 15, 2008, which triggered an intensification  of the financial crisis, U.S. government authorities took actions that  signaled a stronger near-term commitment to prevent the failure of  systemically important financial institutions. On the day after Lehman  Brothers’ bankruptcy announcement, the Federal Reserve Board  authorized up to $85 billion of credit assistance for American International  Group, Inc. (AIG) to prevent its failure. In addition, on September 29,  2008, the Secretary of the Treasury invoked the systemic risk exception  for the first time since the enactment of the FDIC Improvement Act of  1991(FDICIA) to authorize FDIC to provide assistance to avert the failure  of Wachovia Corporation—then the fourth-largest banking organization in  terms of assets in the United States—by facilitating Citigroup Inc.’s  acquisition of its banking operations.
The G7 is an informal forum of coordination among Canada, France, Germany, Italy,  Japan, the United Kingdom, and the United States. also took steps to prevent the failures of large financial institutions.  Examples of large foreign financial institutions that received firm-specific  assistance from their governments include Royal Bank of Scotland Group  PLC (United Kingdom) and UBS (Switzerland).
Since the onset of the financial crisis, the largest banks have grown  bigger in many major advanced economies, even as the financial sector  has shrunk, and U.S. and foreign policymakers have acknowledged that  crisis policy interventions raised moral hazard concerns. As discussed  earlier, market perceptions that some firms are too big to fail can distort  market participants’ incentives to properly price and restrain risk-taking by  these firms. U.S. regulators have coordinated with foreign counterparts  through the G20 and the Financial Stability Board to develop a policy  framework for addressing the risks posed by large, complex financial  institutions. In November 2010, G20 leaders endorsed the Financial  Stability Board’s framework for addressing too-big-to-fail concerns. The  framework aims to reduce the probability and impact of the failure of  systemically important firms. Key elements of this framework include  developing effective resolution regimes and strengthening capital  standards for systemically important financial institutions. FDIC, the  Federal Reserve Bank of New York, and Treasury helped to develop  standards the Financial Stability Board issued for effective resolution  regimes in October 2011. In addition, U.S. banking regulators have  worked with their foreign counterparts to develop a strengthened capital  regime that will require global systemically important banks to have   U.S. federal financial regulators are  additional loss absorbing capacity.implementing these and other elements of the Financial Stability Board’s  framework for addressing too big to fail as part of the process of  implementing relevant Dodd-Frank Act provisions.
subsections: section_title: Dodd-Frank Act Provisions
paragraphs: U.S. federal financial regulators have made progress in implementing  Dodd-Frank Act provisions and related reforms to restrict future  government support and reduce the likelihood and impacts of the failure  of a systemically important financial institution (SIFI). be grouped into four general categories: (1) restrictions on regulators’  emergency authorities to provide assistance to financial institutions; (2)  new tools and authorities for regulators to resolve a failing SIFI outside of  bankruptcy if its failure would have serious adverse effects on the U.S.  financial system; (3) enhanced regulatory standards for SIFIs related to  capital, liquidity, and risk management; and (4) other reforms intended to  reduce the potential disruptions to the financial system that could result  from a SIFI’s failure.
Restrictions on Emergency Authorities. The Dodd-Frank Act revised  Federal Reserve Board and FDIC emergency authorities so that  emergency assistance can no longer be provided to assist a single and  specific firm but rather can only be made available through a program  with broad-based eligibility—that is, a program that provides funding  support to institutions that meet program requirements and that choose to  participate.
While the Dodd-Frank Act does not use the term “systemically important financial  institution,” this term is commonly used by academics and other experts to refer to bank  holding companies with $50 billion or more in total consolidated assets and nonbank  financial companies designated by FSOC for Federal Reserve supervision and enhanced  prudential standards. § 165(d)(1), 124 Stat. at 1426 (codified at 12 U.S.C. § 5365(d)(1)). agencies may jointly decide to impose more stringent regulatory  requirements on the company.
Orderly Liquidation Authority. OLA gives FDIC the authority, subject to  certain constraints, to resolve large financial firms, including  nonbanks, outside of the bankruptcy process. This authority allows  for FDIC to be appointed receiver for a financial firm if the Secretary of  the Treasury determines, among other things, that the firm’s failure  and its resolution under applicable federal or state law, including  bankruptcy, would have serious adverse effects on U.S. financial  stability and no viable private-sector alternative is available to prevent  the default of the financial company. While the Dodd-Frank Act does  not specify how FDIC must exercise this authority, FDIC is developing  an approach to resolving a firm under OLA that it refers to as the  Single Point-of-Entry (SPOE) approach.
Under the SPOE approach, FDIC would be appointed receiver of the  top-tier U.S. parent holding company of a financial group determined  to be in default or in danger of default following the completion of the  appointment process set forth under the Dodd-Frank Act. Immediately  after placing the parent holding company into receivership, FDIC  would transfer assets (primarily the equity and investments in  subsidiaries) from the receivership estate to a bridge financial holding  company. By allowing FDIC to take control of the firm at the holding  company level, this approach is intended to allow subsidiaries  (domestic and foreign) carrying out critical services to remain open  and operating. In a SPOE resolution, at the parent holding company  level, shareholders would be wiped out, and unsecured debt holders  would have their claims written down to reflect any losses that  shareholders cannot cover. Under the Dodd-Frank Act, officers and  directors responsible for the failure cannot be retained.
The new resolution authority under the Dodd-Frank Act provides a  back-up source for liquidity support, the Orderly Liquidation Fund,  which could provide liquidity support to the bridge financial company if  customary sources of liquidity are unavailable. The law requires  FDIC to recover any losses arising from a resolution by collecting  assessments from bank holding companies with $50 billion or more in  consolidated assets, nonbank financial holding companies designated  for supervision by the Federal Reserve Board, and other financial  companies with $50 billion or more in consolidated assets. §165(a)(1), 124 Stat. at 1423 (codified at 12 U.S.C. § 5365(a)(1)). ratios above specified standards, under both normal and adverse  conditions. In addition, the Federal Reserve Board has announced  its intention to apply capital surcharges to some or all firms based on  the risks these firms pose to the financial system.
Liquidity requirements. The act required the Federal Reserve Board to  establish liquidity standards, which as finalized include requirements  for covered firms to hold liquid assets that can be used to cover their  cash outflows over short periods and in stressed conditions. In  addition, the Federal Reserve Board, FDIC, and OCC have issued a  proposed rule that would implement a minimum liquidity requirement  that is consistent with the Basel III liquidity coverage ratio and would  apply to internationally active U.S. banking organizations and U.S.  depository institutions with $250 billion or more in total consolidated  assets.
Risk management requirements. Publicly traded covered firms must  establish a risk committee and be subject to enhanced risk  management standards.
Stress testing requirements. The Federal Reserve Board is required  to conduct an annual evaluation of whether covered firms have  sufficient capital to absorb losses that could arise from adverse  economic conditions.
The Federal Reserve Board has been implementing the enhanced  standards required by the Dodd-Frank Act in conjunction with its  implementation of Basel III, a set of risk-based capital, leverage, and  liquidity standards developed by the Basel Committee on Banking  Supervision. The Basel capital reforms include a risk-based capital  surcharge that will apply to financial institutions that have been  designated as GSIBs. Further, the U.S. banking agencies have already  adopted a leverage capital surcharge that will apply to the eight U.S.  banking organizations that are GSIBs.
Other Reforms. The act includes other reforms that could help reduce the  likelihood or impacts of a SIFI’s failure.
Authorities related to SIFI size and complexity. The Dodd-Frank Act  grants regulators new authorities to take certain actions if they  determine that a SIFI poses risks of serious adverse effects on the  stability of the financial system. These include the authority for the  Federal Reserve Board to require a SIFI to meet even stricter  regulatory standards, the authority for the Federal Reserve Board to  limit (with the approval of FSOC) the ability of a SIFI to merge with  another company if it determines that the merger would pose a grave  threat to U.S. financial stability, and, as noted above, the joint  authority for the Federal Reserve Board and FDIC to require a firm to  take steps to become more resolvable in bankruptcy.
Volcker rule. Section 619 of the Dodd-Frank Act (also known as the  Volcker rule) generally prohibits proprietary trading by insured  depository institutions and their affiliates and places restrictions on  sponsorship or investment in hedge and private equity funds. The  Volcker rule’s restrictions may have greater impacts on larger bank  holding companies that have been more involved in the types of  activities the rule restricts. To the extent that Volcker rule  implementation prevents these large institutions from engaging in  certain risky activities, it could serve to reduce the likelihood of their  failure.
Swaps clearing and margin requirements. Title VII of the Dodd-Frank  Act establishes a new regulatory framework for swaps to reduce risk,  increase transparency, and promote market integrity in swaps  markets. As we previously reported, requirements for swaps to be  cleared through clearinghouses can reduce the vulnerability of the  financial system to the failure of one or a few of the major swap  dealers by transferring credit risk from the swap counterparties to the  clearinghouse. At the same time, experts have pointed out that  clearinghouses concentrate credit risk and thus represent a potential  source of systemic risk. A benefit of the central clearing requirement  is that clearinghouses require members to post margin for their trades  and the Dodd-Frank Act also includes provisions that require  regulators to develop margin requirements for uncleared swaps.  These new requirements could help reduce systemic risk by  preventing the build-up of large, undercollateralized exposures.
Although federal financial regulators have finalized a number of rules  related to these reforms, implementation of some key reforms has not yet  been completed. For example, FDIC has largely completed the core  rulemakings necessary to carry out its systemic resolution responsibilities,  and is continuing to develop its SPOE approach. FDIC requested public  comments on its SPOE resolution strategy in December 2013, and the  comment period closed in March 2014. finalized certain rules that would subject SIFIs to enhanced prudential  standards. For example, regulators have not finalized rules on single- counterparty credit limits.
Resolution of Systemically Important Financial Institutions: The Single Point of Entry  Strategy, 78 Fed. Reg. 243 (Dec. 18, 2013); Resolution of a Systemically Important  Financial Institution: The Single Point of Entry Strategy, 79 Fed. Reg. 9899 (Feb. 21,  2014).
section_title: Reforms Have Reduced Expectations of Government Support among Key Market Observers and Increased Regulation for Large Institutions
paragraphs: While views among investment firms we interviewed and credit rating  agencies varied, many believe the Dodd-Frank Act has reduced but not  eliminated the possibility of a government rescue of one of the largest  bank holding companies. Two of the three largest credit rating agencies  cited FDIC’s resolution process as a key factor in their decisions to  reduce or eliminate “uplift”—an increase in the credit rating—they had  assigned to the credit ratings of eight of the largest bank holding  companies due to their assumptions of government support for these  firms. Several representatives from large investment firms with whom we  spoke told us that FDIC’s resolution process makes significant progress  in reducing expectations of government support, but several agreed that  uncertainty around its implementation or the circumstances of its use  remains. As such, some market perceptions that the government might  not allow the largest bank holding companies to fail remain and can give  rise to advantages for these firms if these perceptions affect decisions by  investors, counterparties, and customers of these firms. For example,  credit rating agencies’ assignment of higher credit ratings due to assumed  government support can create benefits for these firms, but because  investors may rely on credit ratings to varying degrees, the impact of such  benefits may vary accordingly. In addition, Dodd-Frank Act provisions and  related rules subject the largest firms to higher fees and stricter regulation  that may reduce their risk of failure and increase costs on them relative to  smaller competitors. Officials from FSOC and some of its member  agencies have stated that financial reforms have not completely removed  too-big-to-fail perceptions, but have made significant progress toward  doing so. They anticipate that remaining expectations of government  support will decline as Dodd-Frank implementation progresses.
subsections: section_title: Some Credit Rating Agencies and Large Investors Believe Dodd- Frank Has Reduced the Likelihood of Government Rescues
paragraphs: While views among credit rating agencies and investment firms varied,  many believe the Dodd-Frank Act has reduced but not eliminated the  possibility of a government rescue of one of the largest bank holding  companies. During the financial crisis, credit rating agencies assigned or  increased “uplift”—or an increase in the credit rating—for several large  bank holding companies’ credit ratings to reflect their view that the  increased possibility of government support for these firms reduced the  risk that the firms’ creditors would suffer losses. We reviewed changes  in credit rating agencies’ assumptions about government support over  time and interviewed credit rating agency representatives. Because large  investors do not necessarily rely on credit ratings or rating agencies’  assessments of government support, we obtained perspectives from  representatives of large asset management firms, pension funds, hedge  funds, and other investment firms that purchase debt and equity issued  by bank holding companies.
A firm with a lower standalone credit rating may receive a bigger increase in its rating  from government support than a firm with a stronger standalone rating. holding companies. Fitch and Moody’s reports cited FDIC’s new  resolution authority and a reduced willingness by the U.S. government to  assist a failing bank holding company as key factors influencing these  changes in assumed government support. As of June 2014, S&P had not  changed its level of assumed government support since the financial  crisis. However, in June 2013, S&P noted that regulatory developments  may lead it to reassess its assumptions of government support for the  eight bank holding companies. The three credit rating agencies each  noted that their remaining assumptions of government support reflected  continued uncertainty about the ability of the U.S. government to  effectively resolve one of the largest bank holding companies in OLA. In  September 2013, Fitch indicated that it would conduct a global review of  its support ratings and in March 2014, Fitch reported that it expects to  remove its support rating floor for several of the largest U.S. bank holding  companies within the next one or two years. In November 2013,  Moody’s removed all uplift from assumed government support from its  credit ratings for the remaining eight large bank holding companies.Moody’s cited regulators’ substantial progress in establishing the SPOE  receivership framework as a main consideration in their decision to  remove the uplift. They noted that the SPOE framework would allow FDIC  to impose losses on the creditors of a U.S. bank holding company to  recapitalize and preserve the operations of the bank’s systemically  important subsidiaries in a stress scenario. As a result, they believe that  the holding company creditors of systemically important U.S. banks are  unlikely to receive government support.
Representatives of large investment firms with whom we spoke said that  they rely primarily on their own assessments of government support when  investing in financial institutions, and they identified OLA and other  reforms as factors influencing their views. While representatives of  several firms said that Dodd-Frank reforms have significantly reduced or  eliminated expectations of government rescues, others said they continue  to expect that the government would rescue one of the largest bank  holding companies under certain scenarios if policymakers judged the  potential costs to the economy from such a failure to be too great.
Investors generally cited progress on OLA and enhanced regulatory  standards for the largest bank holding companies as among the most  important factors influencing their views on the likelihood of government  support, and many considered living wills and other reforms to be less  significant factors.
FDIC’s resolution process. Investors with whom we spoke said that  FDIC’s progress in developing its resolution process to implement OLA as  an alternative to bankruptcy has caused them to significantly reduce their  expectations of government support, but uncertainty around its  implementation and circumstances of its use remains. Although several  investors believed that FDIC’s resolution process is credible for managing  a single large failure, two expressed doubts about whether it could be  used to resolve multiple failing firms in a systemic crisis. They noted that  if the economic costs of a large firm’s failure were judged to be too high,  the federal government might not want to risk using OLA if regulators  believed it would destabilize markets. Two investors noted that in the  event that concerns about destabilizing markets led the federal  government to provide emergency assistance to a failing firm in lieu of  using OLA, policymakers might face political pressure to structure the  assistance in a manner that imposed losses on creditors. Other factors  being equal, an investor’s belief that there is a possibility of incurring  losses even if the government prevents a firm’s failure would reduce that  investor’s willingness to provide funds to that firm on more favorable  terms because of a too-big-to-fail perception. Because OLA is untested,  some uncertainty may exist about its viability as an alternative to  bankruptcy and government rescues until it is used.
Some investors identified areas where further progress is needed to  enhance the credibility of OLA. First, some market observers have  pointed to opportunities to further minimize the adverse market impacts  that could result from resolving a firm under OLA. For example, although  OLA provides for a 1-day stay on qualified financial contracts to allow for  the selection of contracts to transfer to the bridge company, derivatives  contracts written under the laws of other countries could allow  counterparties to close out those contracts immediately, possibly posing  liquidity issues for the firm and leading it to sell assets at depressed  prices into the market. Some regulatory officials have said that cross- border agreements that create conformity in the treatment of derivatives  contracts in resolution processes would enhance OLA’s effectiveness and  practicality as a resolution tool. In addition, some investors noted that  progress on the Federal Reserve’s planned proposal for a minimum long- term debt requirement could create greater certainty that the largest bank  holding companies would have enough equity and debt to absorb losses  and recapitalize their operating subsidiaries under OLA.
Enhanced regulatory standards. Many investment firm representatives  credited enhanced regulatory standards for the largest bank holding  companies with improving the safety and soundness of these firms and  reducing the likelihood that they would experience distress that could  result in failure or government support. One representative from a large  investment firm said that the best defense against banks needing  government support is to make sure they are well-capitalized. Similarly,  another investment firm representative said that higher capital ratios and  strengthened balance sheets have given confidence to the markets that  the institutions are more sound, in turn reducing the likelihood that they  would fail and potentially receive government assistance. A  representative from one large asset management firm said that enhanced  capital and liquidity standards are a positive from a debt holder’s  perspective because increased capital provides a bigger buffer to absorb  losses and increased liquidity makes a run on the firm less likely.
Living wills. Several investors said the living wills may have positive  effects, but some investors have expressed doubts about the  effectiveness of the plans, with one investor citing a lack of public  transparency. In a public comment letter to FDIC, The Credit Roundtable,  a financial industry association, noted that additional living will disclosures  would improve the market’s ability to gauge the level of risk under a  SPOE scenario. Additionally, while the purpose of living wills is to make  SIFIs resolvable in bankruptcy, several large investors said they assume  that a failing SIFI would be resolved through OLA.
section_title: Remaining Market Expectations of Government Support Can Have Benefits for Large Firms
paragraphs: Remaining market assumptions about government support can give rise  to advantages for the largest bank holding companies in three broad  categories to the extent these assumptions affect decisions by investors,  counterparties, and customers of these firms. Those categories are  funding costs, financial contracts that reference ratings, and ability to  attract customers.
subsections: section_title: Funding Costs
paragraphs: Market beliefs about government support could benefit a firm by lowering  its funding costs. However, the extent to which this occurs depends in  part on the extent to which providers of funds—such as depositors, bond  investors, and stockholders—rely on credit ratings that assume  government support or incorporate their own expectations of government  support into their decisions to provide funds. For example, an investor  that relies on credit ratings may view a firm with a rating that incorporates  implied government support as having lower risk—other factors being  equal—and may be more inclined to invest in the firm and accept a lower  interest rate or return on the firm’s obligations. These effects can be more  pronounced during a financial crisis, particularly if market strains cause  credit rating agencies to reduce ratings more for firms they believe the  government would not rescue and if providers of funds seek to reduce  their risk exposures to firms they believe are not too big to fail.
Several factors influence the extent to which investors rely on ratings. For  example, an investor’s reliance on credit ratings can depend on the extent  to which the investor conducts its own credit analysis. While  representatives of large investment firms with whom we spoke said they  rely primarily on their own assessments of credit risk and do not rely on  credit ratings, smaller investors lacking the resources to do their own  credit analysis may rely more on credit ratings and rating agencies’  assessments of the impact of possible government support on a firm’s  risk profile. In addition, while an investment firm’s assessment of  government support can be relevant to funds that it actively manages, it  may not incorporate this factor into the investment decisions of funds that  it manages using passive investment strategies.representatives of large investment firms said that while they do not rely  on credit ratings for investment decisions, they pay attention to them  when managing funds for clients whose investments must meet minimum  credit rating requirements and for clients who may use credit ratings to  assess their performance.
Representatives of large investment firms with whom we spoke generally  said their views on the likelihood of government support do not affect their  investment decisions. Some representatives of investment firms said that  while they believe some probability of government rescues remains, there  is too much uncertainty surrounding future government support to factor it  into their current investment decisions. Several bond investors said it is  difficult to distinguish any pricing impacts from market expectations of  government support from the variety of other factors related to firm size  that can impact debt pricing and investors’ investment decisions. For  example, compared to smaller institutions, large bank holding companies  issue bonds more frequently and in larger amounts, which increases the  liquidity of their bonds. Investors may accept lower interest rates on more  liquid bonds because more liquid bonds can be sold more easily without  reducing the price. In the section addressing the second objective of this  report, we analyze the existence and size of potential funding cost  advantages for the largest bank holding companies using quantitative  approaches that control for factors outside of government support that  can influence funding cost differences.
section_title: Financial Contracts That Reference Ratings
paragraphs: Higher credit ratings from assumed government support can also benefit  firms through private contracts that reference credit ratings. For example,  derivative contracts often tie collateral requirements to a firm’s credit  rating. Representatives of some large bank holding companies said that  reduced credit ratings would require them to post more collateral.  Additional collateral requirements would demand additional funds that  could otherwise be used in other investments. The largest bank holding  companies disclose information in their financial statements about how a  credit rating downgrade could cause them to post more collateral. While  estimates of these collateral impacts have varied over time and across  firms, several of these firms have estimated that a downgrade in their  credit rating could require them to post between $1 billion and $4 billion of  additional collateral, depending on the size of the downgrade. Another  way that private contracts can reference credit ratings is by setting  minimum credit rating requirements. Examples of such requirements  include investment funds that cannot purchase securities that are below  minimum ratings requirements and counterparties that will not accept a  letter of credit from a bank with a low credit rating.
section_title: Ability to Attract Customers
paragraphs: Corporate customers with whom we spoke expressed varying views on  the degree to which expectations of government support influence their  banking decisions. Two corporate customers with whom we spoke said  that they believe the government would intervene to prevent the failure of  the largest bank holding companies, but that potential government  support is only one of several factors they consider in choosing a bank  and is not necessarily a decisive factor. Several corporate treasurers  identified size-related factors that are unrelated to government support  that make them more inclined to use the largest banks for their banking  needs. For example, treasurers of global firms noted that the largest U.S.  banks have the geographic presence and ability to provide funding on the  scale they need to support their operations around the world. One  corporate customer noted that although the company’s credit facility  includes both regional banks and some of the largest banks, they tend to  use the services of large banks more because of their capacity for  handling large transactions and the variety of their business lines.
However, while two treasurers said that they tend to select the largest  U.S. banks primarily for reasons that are unrelated to government  support, their beliefs about which banks would be rescued by the  government can impact how they manage their risk exposures to banks of  different sizes. For example, a treasurer for a large domestic corporation  said that the possibility of government rescues can be a factor when  evaluating counterparty risk and the safety of deposits. She noted that in  normal economic conditions, the likelihood of government support for  banks is not a significant factor, but when markets become strained, her  company may reduce its deposits and other exposures to regional banks  they believe the government would allow to fail. Outside of these  treasurers, a treasurer from a large global company said that potential  government support may impact his company’s banking decisions  indirectly through credit ratings. He noted that the company uses credit  ratings as a factor in assessing a bank’s creditworthiness and adjusting  its exposures to banks. For example, if a bank’s credit rating falls, the  company may reduce its intraday exposure to that bank by shifting  deposits and other exposures away from that bank. A few corporate  customers told us they do not consider the possibility of government  support for large banks when they decide how to allocate their banking  business.
section_title: Stricter Capital and Other Regulatory Standards May Reduce Risk of Failure and Increase Costs for Largest Firms
paragraphs: The Dodd-Frank Act imposes new and higher fees on large bank holding  companies and requires the Federal Reserve Board to subject large bank  holding companies to enhanced regulatory standards for capital, liquidity,  and risk management. These enhanced standards may help to reduce  the likelihood and potential market impacts of the failure of a large bank  holding company. Taken together, higher fees, stricter regulatory  standards, and other reforms could increase costs for the largest bank   New or revised fees  holding companies relative to smaller competitors.and assessments impose higher direct costs on bank holding companies  with more than $50 billion in total assets.
Deposit insurance assessments. The Dodd-Frank Act required  FDIC to change the definition of an insured depository institution’s  assessment base, which can affect the amount of deposit insurance  assessment the institution pays into the deposit insurance fund.  According to FDIC, this change shifted some of the overall  assessment burden from smaller banks to larger institutions that rely  less on deposits but did not affect the overall amount of assessment  revenue collected. The base was changed from total domestic  deposits to average consolidated total assets minus average tangible  equity. The largest bank holding companies generally saw the largest  percentage increases in their deposit insurance assessments  because they rely less on domestic deposits for their funding than  smaller institutions. One of the largest bank holding companies  reported that the change to the assessment calculation resulted in a  $600 million increase in its deposit insurance assessments in 2011. In  the quarter after the rule became effective, those banks with less than  $10 billion in assets saw a 33 percent drop in their assessments (from  about $1 billion to about $700 million), while those banks with over  $10 billion in assets saw a 17 percent rise in their assessments (from  about $2.4 billion to about $2.8 billion).
Fees on SIFIs. In addition, the Dodd-Frank Act directs the Federal  Reserve Board to collect fees from bank SIFIs equal to the expenses  the Federal Reserve Board estimates are necessary or appropriate to  carry out its supervision and regulation of those companies. In  addition, the Dodd-Frank Act directs Treasury to collect assessments  from bank and nonbank SIFIs to fund the operations of the Office of  Financial Research. These assessments totaled $137 million in 2012  and $35 million in 2013.
The Dodd-Frank Act requires the Federal Reserve Board to subject large  bank holding companies to heightened standards for capital, liquidity, and  stress testing, as well as other provisions, all of which could reduce the  risk of their failure and the costs that their distress could impose on the  financial system. Following Dodd-Frank enactment, bank SIFIs  significantly increased their capital and liquidity in advance of finalization  of new rules for capital, leverage, and liquidity standards. As of December  31, 2013, the six largest U.S. GSIBs had an average tier 1 common  equity capital ratio of 12.1 percent, compared to the 4.5 percent minimum  required under Basel III and an average of 8.4 percent among these firms  as of December 31, 2009. In addition, pursuant to the Dodd-Frank Act,  the Federal Reserve Board conducts stress testing and evaluates the  capital planning process of large bank holding companies to help ensure  these firms are resilient to periods of economic or financial stress. In the  most recent round of capital planning reviews, the Federal Reserve Board  rejected the capital plan of one U.S. GSIB and required another to  resubmit its capital plan after errors were discovered. Pending approval  of their revised capital plans, the Federal Reserve Board did not allow  proposed actions by these firms, such as dividend increases, that would  have reduced their capital. In April 2014, U.S. bank regulators adopted a  new rule that strengthens the leverage ratio standards for the largest,  most interconnected U.S. banking organizations.
Beyond the new rules and regulatory reviews to ensure capital adequacy,  the Federal Reserve Board has indicated that eight of the largest U.S.  bank holding companies will be subject to a capital surcharge—an  increase in their risk-based capital requirement—based on their size,  complexity, and interconnectedness. Federal Reserve Board officials  have stated that the capital surcharge is intended to force the largest  bank holding companies to internalize the costs they could impose on the  financial system from their systemic footprint. Federal Reserve Board and  Treasury officials said that this capital surcharge could also help to offset  any funding cost advantages that remain from market perceptions that the  government would not allow the largest bank holding companies to fail.
Higher capital and liquidity requirements for banks can increase their  funding and other costs. For example, higher capital requirements can  require banks to increase the portion of their funding that comes from  equity capital rather than debt, which can increase funding costs.  In  prior work, we have summarized the results of studies by the Bank for  International Settlements and others on the benefits and costs of  increasing capital requirements for banks, but these studies generally  estimated cost impacts to the economy rather than the incidence of  increased costs for the institutions themselves. While banks can respond  to additional costs in a variety of ways, including passing on some costs  to borrowers by charging higher interest rates on loans, a Federal  Reserve Board official noted that costs associated with the GSIB capital  surcharges—which will not apply to most banks and will not apply evenly  among the GSIBs—may be more difficult for the largest bank holding  companies to pass on to customers.
In theory, increasing the required proportion of equity funding relative to debt funding  should not affect a firm’s overall cost of funding as it reduces the risk that the firm will fail,  thereby reducing the returns demanded by both equity and debt holders. However, certain  government policies make equity financing (such as through issuing stock to investors)  more expensive for financial institutions than debt financing. For example, interest on debt  is tax deductible, while dividends on equity securities are not. In addition, bank deposits  benefit from federal guarantees and the interest rates a bank pays on its insured deposits  may not fall as capital levels and the perceived safety of the firm increases. periodically submit resolution plans to the Federal Reserve and FDIC, as  well as to conduct company-run stress tests semiannually. Regulators  and industry officials have stated that SIFIs have devoted significant  staffing resources to developing these resolution plans. According to  industry representatives, stress testing requires newly covered firms to  incur significant compliance costs associated with building information  systems, contracting with outside vendors, recruiting personnel, and  developing stress testing models that are unique to their organization.  Furthermore, changes to the market infrastructure for swaps—such as  clearing and exchange-trading requirements—and real-time reporting  requirements for designated major swap dealers or major swap  participants will require firms to purchase or upgrade information systems.  Industry representatives and regulators said that while some compliance  costs of the derivatives reforms could be recurring, a large part of these  costs will come from one-time upfront investments to update processes  and technology. Additionally, by generally prohibiting banks from  engaging in proprietary trading and limiting their ability to sponsor or  invest in hedge and private equity funds, the Volcker rule restrictions  could eliminate past sources of trading and fee income for some banks.
As we have noted in prior work, measuring the costs of financial  regulation is challenging because of the multitude of intervening  variables, the complexity of the financial system, and data limitations.  For example, the extent to which regulated institutions pass on a portion  of their increased costs to their customers may be impacted by  competitive forces or other factors. Other sources of uncertainty, such as  the potential for regulatory arbitrage, add to the challenges of estimating  the act’s potential costs. For example, increased regulation could cause  certain financial activities in the United States to move to foreign  jurisdictions with less stringent regulations. U.S. regulators have  acknowledged the importance of harmonizing international regulatory  standards and noted that it can be advantageous for the United States to  be the leader in implementing new regulatory safeguards.
section_title: Agencies See Progress in Addressing Too-Big-to-Fail Perceptions and Expect Further Progress as Reforms Are More Fully Implemented
paragraphs: Officials from FSOC and its member agencies have stated that financial  reforms have not completely removed too-big-to-fail perceptions but have  made significant progress toward doing so. In a December 2013 speech,  Treasury Secretary Jack Lew said there is growing recognition of the  Dodd-Frank reforms and that market analysts are factoring them into their  assumptions. However, he noted that there is still more work to be done.
Under the Dodd-Frank Act, FSOC is, among other things, charged with  promoting market discipline by eliminating expectations on the part of  shareholders, creditors, and counterparties of large bank holding  companies that the U.S. government will shield them from losses in the  event of failure. FSOC and its member agencies monitor progress in  addressing expectations of government support primarily through  monitoring progress in implementing relevant Dodd-Frank reforms.  FSOC’s 2014 annual report includes a discussion of progress made on  OLA, enhanced prudential standards, and other relevant reforms.  According to Treasury officials, several key areas require continued  progress:  International regulatory reform. In its 2013 annual report, FSOC  writes that international coordination of financial regulation is essential  to mitigate threats to financial stability. FDIC officials said they  continue to work with foreign regulators to address issues related to  creating a viable process for effecting the orderly resolution of a failing  financial institution with significant cross-border activities. For  example, FDIC is working with foreign counterparts on changes  needed to ensure that derivatives contracts under other countries’  laws include a stay similar to that which applies to U.S. contracts  under Dodd-Frank to prevent termination of these contracts by  counterparties of a firm pulled into resolution. Federal Reserve Board  staff said U.S. regulators are considering steps that may be needed to  help ensure that foreign regulators do not take disruptive actions with  respect to foreign operations of a U.S. firm pulled into resolution. They  noted that global U.S. SIFIs may need to create intragroup loss  absorbency arrangements that provide clarity and assurance to  foreign regulators about how loss absorbency from the U.S. holding  company will be made available to support foreign operations during a  resolution.
The Federal Reserve’s long-term debt requirement. The Federal  Reserve Board has identified the implementation of a long-term debt  requirement as a regulatory priority that it and other agencies are  actively considering. In testimony before the Senate Banking  Committee, Federal Reserve Board Governor Daniel Tarullo said that  successful resolution without taxpayer assistance would be most  effectively accomplished if a firm has sufficient long-term, unsecured  debt to absorb additional losses and to recapitalize the business  transferred to a bridge operating company.
General education of market participants on reforms. Treasury  officials identified the education of market participants as a key area  for progress. Public outreach and education often take the form of  speeches from agency officials and meetings with industry  stakeholders. Regulators also solicit feedback on proposed  rulemakings and regulations during public comment periods. For  example, on December 18, 2013, FDIC published a public notice on  the framework for a SPOE approach for resolution of failed financial  institutions under OLA and solicited comments from the public through  February 18, 2014, before subsequently extending the comment  period through March 20, 2014.
Treasury officials also monitor market trends and outside research to  inform their assessment of progress in addressing too-big-to-fail  perceptions. Treasury staff have looked at trends in bond prices, credit- default-swap prices, and other market data for bank holding companies of  different sizes for evidence that investors have reduced their expectations  of government support. Treasury staff also monitor relevant outside  research, including a growing body of research by academics and others  that has used quantitative approaches to analyze the existence and size  of potential funding cost advantages that the largest bank holding  companies could receive because of market expectations of government  support. The next section of this report includes a summary of selected  studies in this literature and discusses the strengths and limitations of the  methods they use. FSOC and Treasury staff have reviewed these studies  and noted that while the studies have limitations, their findings are  consistent with a reduction in expectations of government support  following the Dodd-Frank Act.
section_title: Evidence Suggests Large Banks Had a Funding Cost Advantage over Small Ones during the Financial Crisis That May Have Declined or Reversed Since
paragraphs: Our analysis and the results of studies we reviewed provide evidence that  the largest bank holding companies had lower funding costs than smaller  bank holding companies during the 2007-2009 financial crisis but that  differences may have declined or reversed in more recent years. To  inform our econometric approach, we reviewed studies that estimated  funding cost differences between large and small financial institutions that  could be associated with the perception that some institutions are too big  to fail. Studies we reviewed generally found that the largest financial  institutions had lower funding costs during the 2007-2009 financial crisis  but that the difference between the funding costs of the largest and  smaller financial institutions has since declined. In some cases these  findings could be interpreted as evidence of advantages driven by too- big-to-fail perceptions; however, these empirical analyses are imperfect  and contain a number of limitations that could reduce their validity or  applicability to U.S. bank holding companies. Our analysis, which  addresses certain limitations of these studies, also provides evidence that  large or systemically important bank holding companies had lower  funding costs than smaller bank holding companies during the 2007-2009  financial crisis, which may have been associated with expectations of  government assistance. In addition, our analysis provides some evidence  that funding cost differences may have declined or reversed in recent  years and that large bank holding companies may have had higher  funding costs since the crisis. However, we also analyzed what funding  cost differences might have been since the crisis 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. This  analysis suggests that large bank holding companies might have had  lower funding costs than smaller bank holding companies since the crisis  if levels of credit risk had remained high, indicating that changes in  funding cost differences over time may be due in part to improvements in  bank holding companies’ financial conditions. Although our analysis  improves on certain aspects of prior studies, important limitations remain  and our results should be interpreted with caution.
subsections: section_title: Studies Generally Found the Largest Banks Had Lower Funding Costs during the Financial Crisis but Results Have Limitations
paragraphs: Studies we reviewed generally found that the largest financial institutions  had lower funding costs than smaller ones during the 2007-2009 financial  crisis but that the difference between the funding costs of the largest and  smaller financial institutions has since declined. In some cases these  findings could be interpreted as evidence of advantages driven by too- big-to-fail perceptions; however, these empirical analyses are imperfect  and contain a number of limitations that could reduce their validity or  applicability to U.S. bank holding companies.
We reviewed studies that estimated the funding cost difference between  large and small financial institutions that could be associated with the  perception that some institutions are too big to fail. We evaluated studies  that met the following criteria: (1) used a comparative empirical approach  that attempted to account for differences across financial institutions that  could influence funding costs, (2) included U.S. bank holding companies,  and (3) included analysis of data from 2002 or later. See our scope and  methodology section for more information on our criteria and approach.
The 16 studies we reviewed made a wide variety of methodological  decisions and came to a range of conclusions. We present the variety of  methodological decisions along two key dimensions—which source of  funding is analyzed (e.g., deposits, bonds) and time period of analysis—in  table 2 below. The source of funding that is analyzed is an important  methodological decision because investors may have differing  expectations regarding the likelihood that various sources of funding  might receive government support, and these expectations could differ by  the size of the financial institution. Results could differ across studies  because of differences in creditor priority (subordinated debt versus  senior debt) or maturity (bonds that mature several years in the future  versus deposits that can be demanded at any time). We also include  information in table 2 on the reported affiliations of the study authors.
Studies we reviewed generally found that the largest financial institutions  had lower funding costs than smaller ones during the 2007-2009 financial  crisis, but that the difference between the funding costs of the largest and  smaller financial institutions has since declined. For example, one study  estimated that large U.S. financial institutions had roughly 100 basis  points lower bond funding costs than smaller ones in 2009, but this  difference had declined to around 40 basis points by 2011. Similarly, a  study of U.S. bank credit default swaps found that large U.S. bank holding  companies had roughly 100 basis points lower funding costs in 2009, but   In some  this difference had declined to around 15 basis points in 2013.cases these differences could be interpreted as evidence of funding cost  advantages driven by too-big-to-fail perceptions. In other cases,  limitations in the studies make it difficult to eliminate other explanations of  why funding cost differences might exist—such as greater liquidity or  diversification that could be associated with size or spurious results driven  by imperfect measures of funding costs. Time period of analysis was  another important difference across studies we reviewed. Few studies in  our review included data beyond 2011. Therefore, most results may not  reflect recent changes in the regulatory environment and market  expectations discussed earlier in the report.
Studies also varied in their approach to identifying financial institutions  that might be perceived as too big to fail, using a variety of size and other  thresholds. For example, some studies measured too-big-to-fail status by  a bank’s assets; however, the threshold between too-big-to-fail and other  banks varied from $50 billion to $500 billion. Several papers estimated  too-big-to-fail status by size relative to industry, such as the largest 20  banks or top 10 percent by assets. These different approaches indicate  that there is no consensus within the literature on which financial  institutions may be considered too big to fail for the purposes of  comparing funding costs.
The studies we reviewed can be grouped into categories based on their  approaches. While all studies included in our review used standard  approaches and attempted to address factors that might account for  differences in funding costs, these empirical analyses remain imperfect.
Regression. Most studies we reviewed adopted a regression  methodology in which some measure of funding costs was explained  by a variety of control variables, such as risk, liquidity, and maturity, to  attempt to account for differences across financial institutions. These  models are standard empirical tools and are flexible in terms of the  information about financial institutions and markets that they can  incorporate. In some instances these models rely on a small number  of indicators that may only imperfectly measure underlying default  risks. As a result, some analyses may not correctly estimate the size  of any too-big-to-fail advantages because they omit important factors  that influence funding costs. In other studies that account for a more  thorough set of factors that influence funding costs, results may be  sensitive to alternative measurements of these factors.
For example,  default risk is an underlying driver of funding costs, and studies may  produce different results by using a bank’s earnings volatility as an  indicator for default risk as opposed to other indicators such as the  quality of a bank’s assets. In addition, liquidity is another important  factor to account for when attempting to explain funding cost  differences—investors charge banks more for less liquid sources of  funding—and some studies do not adequately control for the liquidity  of the funding source. Challenges similar to those involved in  accurately capturing default risk arise in finding appropriate indicators  for a bond’s liquidity.
Equity-based. Three papers we reviewed measured the difference  between observed credit default swap spreads (which approximate  bond funding costs) and hypothetical credit default swap spreads  (which are estimated based on information implied by equity prices).  This approach estimates hypothetical spreads with a standard  theoretical model used in finance that uses the risk of a firm’s equity  to estimate the risk of a firm’s debt. In doing so, the approach  assumes that hypothetical spreads derived from equity prices are not  influenced by any expectations of government support, but that  observed credit default swap spreads are influenced by such  expectations. By comparing the two spreads the approach can  estimate the magnitude of expectations of government support. While  this approach has some advantages, it relies on critical assumptions  about how a limited number of factors influence the risk of default.
As a result, these analyses may also omit important factors that  influence funding costs, such as earnings.
Ratings-based. Two papers used Fitch credit ratings to estimate the  funding cost difference that could be associated with potential  government support. Models based on credit ratings offer a  convenient way to incorporate all the factors the rating agency  considers relevant to default risk and take advantage of the rating  agency’s explicit separation of the impact of expected government  support through, for example, the assignment of a standalone credit  rating (assuming no government support) and a higher credit rating  assuming government support. However, this approach assumes  that all information about market expectations of default risk and  government support are incorporated into credit ratings, which is a  potentially weak assumption. Credit ratings had a limited impact on  the views of large investors we interviewed, as previously discussed.  Moreover, funding costs vary for firms within a particular rating. As a  result, these studies may estimate funding costs with considerable  error. Finally, results of these studies are sensitive to the credit rating  agency used—for example, results based on Moody’s ratings could  be quite different than other rating agencies because Moody’s  removed expectations of government support for U.S. bank holding  companies in 2013.
In addition to the approach-specific limitations, a number of general  limitations related to implementation of the various approaches exist  across studies we reviewed that could reduce their validity or applicability  to U.S. bank holding companies. For example, studies varied in the  countries that were included in the analysis—some studies focused on  the United States, while others included a broad cross-section of more  than 20 countries. Studies that pooled a large number of countries in their  analysis have results that may not be applicable to U.S. bank holding  companies. For example, studies that included Switzerland and Iceland in  their analyses may not apply to the United States because banking  sectors in those countries are much larger relative to the economy. As  noted above, because few studies included data past 2011, results may  not reflect recent changes in the regulatory environment and market  sentiment; for example, the Federal Reserve’s rule for enhanced  prudential standards for large bank holding companies and FDIC’s  proposed strategy for orderly liquidation.
As a result of the limitations associated with these methodological  choices, estimates of the size of the funding cost difference associated  with a too-big-to-fail advantage based on this literature—while suggestive  of general trends—are not definitive and should be interpreted with  caution.
section_title: GAO Analysis Suggests Large Banks Had Lower Funding Costs during the Financial Crisis but This Advantage May Have Declined or Reversed Since
paragraphs: We conducted our own analysis to assess the extent to which the largest  bank holding companies have had lower funding costs as a result of  perceptions that the government would not allow them to fail. Overall, our  analysis provides some evidence that large or systemic bank holding  companies had lower funding costs than smaller ones during the 2007- 2009 financial crisis that may have been associated with expectations of  government assistance. Our analysis provides only limited evidence that  large bank holding companies had lower funding costs since the crisis  and instead provides some evidence that the opposite may have been  true at the levels of credit risk that prevailed in those years. However, 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, our analysis suggests that large bank holding companies might  have had lower funding costs than smaller bank holding companies.  Although our analysis improves on certain aspects of prior studies,  important limitations remain and our results should be interpreted with  caution.
To conduct our analysis, we developed a series of econometric models— models that use statistical techniques to estimate the relationships  between quantitative economic and financial variables—based on our  assessment of relevant studies and expert views. These models estimate  the relationship between bank holding companies’ bond funding costs  and their size, while also controlling for other drivers of bond funding  costs, including credit risk and bond liquidity. Key features of our  econometric approach include the following:
U.S. bank holding companies. To better understand the relationship  between bank holding company funding costs and size in the context  of the U.S. economic and regulatory environment, we only analyzed  U.S. bank holding companies. In contrast, some of the literature we  reviewed analyzed nonbank financial companies and foreign  companies.
2006-2013 time period. To better understand the relationship  between bank holding company funding costs and size in the context  of the current economic and regulatory environment, we analyzed the  period from 2006 through 2013, which includes the recent financial  crisis as well as years before the crisis and following the enactment of  the Dodd-Frank Act. In contrast, some of the literature we reviewed  did not analyze data in the years after the financial crisis.
Bond funding costs. We used bond yield spreads as our measure of  bank holding company funding costs because they are a direct  measure of what investors charge bank holding companies to borrow  money and because they are sensitive to credit risk and hence  expected government support. This indicator of funding costs has  distinct advantages over certain other indicators used in studies we  reviewed, including credit ratings, which do not directly measure  funding costs, and total interest expense, which mixes the costs of  funding from multiple sources.
Alternative measures of size. Size or systemic importance can be  measured in multiple ways, as reflected in our review of the literature.  Based on that review and the comments we received from external  reviewers, we used four different measures of size or systemic  importance: total assets, total assets and the square of total assets,  whether or not a bank holding company was designated a GSIB by  the Financial Stability Board in November 2013, and whether or not a  bank holding company had assets of $50 billion or more.
Extensive controls for bond liquidity, credit risk, and other key  factors. To account for the many factors that could influence funding  costs, we controlled for credit risk, bond liquidity, and other key factors  in our models. We included a number of variables that are associated  with the risk of default, including measures of capital adequacy, asset  quality, earnings, and volatility. We also included a number of  variables that can be used to measure bond liquidity. Finally, we  included variables that measure other key characteristics of bonds,  such as time to maturity, and key characteristics of bank holding  companies, such as operating expenses. Our models include a  broader set of controls for credit risk and bond liquidity than some  studies we reviewed and, as we discuss later, we directly assess the  sensitivity of our results to using alternative controls on our estimates  of funding costs.
Multiple model specifications. In order to assess the sensitivity of  our results to using alternative measures of size, bond liquidity, and  credit risk discussed above, we estimated multiple different model  specifications. We developed models using four alternative measures  of size, two alternative sets of measures of capital adequacy, six  alternative measures of volatility, and three alternative measures of  bond liquidity to assess the impact of using alternative measures on  our results. In contrast, some of the studies we reviewed estimated a  more limited number of model specifications.
Annual estimates of models. To allow for changes in investors’  beliefs about the likelihood of government rescues between the years  of the financial crisis—when emergency government programs  designed to assist financial institutions were available—and the years  following the crisis, our models allow the relationship between bank  holding company funding costs and size to vary over time. In contrast,  some of the studies we reviewed assumed that the relationship  between bank holding company funding costs and size was constant  over time.
Link between size and credit risk. To account for the possibility that  investors’ beliefs about government rescues affect their  responsiveness to credit risk, our models allow the relationships  between bank holding company funding costs and credit risk to  depend on size.
Altogether, we estimated 42 different models for each year from 2006  through 2013 and then used these models to compare bond yield  spreads—our measure of bond funding costs—for bank holding  companies of different sizes but with the same level of credit risk. Figure  1 shows our models’ comparisons of the difference between bond funding  costs for bank holding companies with $1 trillion in assets and average  credit risk and bond funding costs for similar bank holding companies with  $10 billion in assets, for each model and for each year. Each circle and  dash in figure 1 shows the comparison of bond funding costs for a  different model. Circles show model-estimated differences that were  statistically significant at the 10 percent level, while dashes represent  differences that were not statistically significant at that level.dashes below zero correspond to models suggesting that bank holding  companies with $1 trillion in assets have lower bond funding costs than  bank holding companies with $10 billion in assets, and vice versa.
section_title: Estimates of Size-Related Funding Cost Differences Should Be Interpreted with Caution
paragraphs: Our estimates of the relationship between the size of a bank holding  company and the yield spreads on its bonds are limited by several factors  and should be interpreted with caution. These factors present challenges  to using our results and the results of other studies as the basis for public  policy responses to concerns about the risks posed by large financial  institutions.
Investors’ beliefs about the likelihood of government support are  composed of several different elements, including the likelihood that a  bank holding company will fail, the likelihood that it will be rescued by the  government if it fails, and the size of the losses that the government may  impose on investors if it rescues the bank holding company. Like the  methodologies used in the literature we reviewed, our methodology does  not allow us to precisely identify the influence of each of these factors. As  a result, changes over time in our estimates of the relationship between  bond funding costs and size may reflect changes in one or more of these  components, but we cannot identify which with certainty. For example, if  bond funding costs for a bank holding company with $1 trillion are less  than those for a bank holding company with $10 billion but the difference  decreases over time, this trend may indicate that investors believe that  the larger bank holding company is relatively less likely to fail, which  could be the case if the level of credit risk is falling over time, either due to  market pressure, regulatory requirements, or other reasons. This trend  could also indicate that investors believe that the government has  become less likely to rescue the larger bank holding company if it fails or  more likely to impose losses on investors in a rescue.
In addition, our estimates of differences in bond funding costs for bank  holding companies of different sizes may reflect factors other than  investors’ beliefs about the likelihood of government support. We have  taken into account many of the factors that may help explain differences  in yield spreads for bank holding companies of different size, such as  credit risk and bond liquidity. However, we may not have taken into  account all possible factors. If a factor that we have not taken into  account is associated with size, then our results may reflect the  relationship between bond funding costs and this omitted factor instead  of, or in addition to, the relationship between bond funding costs and bank  holding company size.
Our estimates of differences in bond funding costs for bank holding  companies of different sizes may also reflect differences in the  characteristics of bank holding companies that choose to issue bonds.  Bank holding companies that issue bonds may differ from those that do  not in ways that may or may not be observable. If such differences exist  and are unobservable, then our models’ comparisons are likely to be  consistently either too high or too low depending on the relationship  between size and the relevant unobservable characteristic. However, if  bank holding companies that issue bonds differ from those that do not in  ways that are observable in our model, then our models’ comparisons of  bond funding cost differences for bank holding companies of different  sizes are unlikely to be consistently either too high or too low. We found  some evidence that this may be the case. Investors with whom we spoke  told us that larger bank holding companies are generally more likely to  issue bonds than smaller ones because they can issue a large enough  quantity of debt to satisfy investors’ demand for liquidity and to allow  investors to make a large enough investment to cover their transaction  costs. Thus, size, which is observable, may be an important difference  between bank holding companies that issue bonds and those that do not.  Importantly, bank holding company size matters in this case because it is  associated with bond issue size, which we control for, not because it is  associated with investors’ beliefs about government rescues.
In general, our estimates of the impact of size on bond funding costs may  reflect a relationship between size, credit risk, or other explanatory  variables and the part of bond funding costs that is not explained by our  model (endogeneity). This could occur if any of our control variables are  influenced by bond funding costs. In this case, our estimates of the  magnitude of the association between size and bond funding costs will be  imperfect and our ability to infer a causal relationship between size and  bond funding costs will be limited.
Historical estimates of differences in bond funding costs for bank holding  companies of different sizes are not indicative of future differences. As we  have discussed, our estimates of the historical relationship between bank  holding company size and bond funding costs vary from year to year.  Thus, it is likely that the relationship between bond funding costs and  bank holding company size may change in the future. As we have noted,  the Dodd-Frank Act imposes new and higher fees on large bank holding  companies and requires the Federal Reserve Board to subject large bank  holding companies to enhanced regulatory standards for capital, liquidity,  and risk management. These enhanced standards may help to reduce  the likelihood that a large bank holding company will fail, which may in  turn alter investors’ beliefs about the likelihood of government support  and thus affect the size of any differences in yield spreads on bonds  issued by large and small bank holding companies. Improvements in  economic conditions, such as faster economic growth and lower  unemployment, may have a similar effect. Finally, changes in the  structure of financial markets, such as an increase in the share of credit  provided by nonbank financial companies that reduces the systemic  importance of large bank holding companies, could also lead investors to  change their beliefs about government rescues in future episodes of  individual or system-wide distress.
Finally, our estimates of the differences in bond funding costs for bank  holding companies of different sizes do not necessarily reflect the harm  that the failure of a large bank holding company could do to the economy.  Bond funding costs reflect the risk that a bank holding company might fail  and not be able to fully repay its investors. However, parties other than  investors may be harmed if a bank holding company fails. For example,  the customers of a failed bank holding company may be harmed if they  have less access to credit or to specialized services provided by the bank  holding company, which could be the case if the bank holding company  has a large enough share of the market.
section_title: Agency Comments and Our Evaluation
paragraphs: We made copies of the draft report available to FDIC, the Federal  Reserve Board, FSOC, OCC and Treasury for their review and comment.  We also provided excerpts of the draft report for technical comment to  Fitch, Moody’s, Standard and Poor’s, and the International Monetary  Fund. All of these agencies and third parties, except for FSOC, provided  technical comments, which we have incorporated, as appropriate.
In its written comments, which are reprinted in appendix II, Treasury  generally agreed with the results of our analysis and commented that our  draft report represents a meaningful contribution to the literature.  Treasury further commented that the Dodd-Frank Act makes clear that  shareholders, creditors and executives—not taxpayers—will be  responsible if a large company fails and that our results reflect increased  market recognition that the Dodd-Frank Act ended “too big to fail” as a  matter of law. While our results do suggest bond funding cost differences  between large and smaller bank holding companies may have declined or  reversed since the 2007-2009 financial crisis, we also report that a higher  credit risk environment could be associated with lower bond funding costs  for large bank holding companies than for small ones. Furthermore, as we  have noted, many market participants we spoke with believe that recent  regulatory reforms have reduced but not eliminated the perception of “too  big to fail” and both they and Treasury officials indicated that additional  steps were required to address “too big to fail.” As discussed in the final  section of our report on page 56, changes over time in our estimates of  the relationship between bond funding costs and size may reflect  changes in one or more components of investors’ beliefs about  government support—such as their views on the likelihood that a bank  holding company will fail and the likelihood it will be rescued if it fails—but  we cannot precisely identify the influence of each of these components  with certainty. A decline or reversal of funding cost advantages for large  bank holding companies could indicate that investors believe that the  government has become less likely to rescue a large bank holding  company if it fails or more likely to impose losses on investors in a  rescue. This trend could also indicate that investors believe that large  bank holding companies are less likely to fail.
On separate dates in July 2014, Treasury, the Federal Reserve Board,  OCC and FDIC provided via email technical comments related to the draft  report’s analysis of funding cost differences between large and small  bank holding companies. We summarize their most significant comments  and our responses below.
Treasury provided comments on our presentation of the impact of  a higher credit risk environment on our analysis of bond funding  costs and the statistical robustness of these results. In response  to these comments, we revised text on the Highlights and in the  report body to clarify that the results of this analysis reflect  hypothetical scenarios and to provide greater attention to the  potential impacts of regulatory reforms. With respect to the  statistical robustness of these results, we note that the draft report  contained clear information about the statistical significance of our  results. Importantly, we note that whether one considers the  estimates from all 42 models for 2013 or only the 10 models with  statistically significant results, higher credit risk substantially  increases (1) the number of models that suggest bond funding  costs would have been lower for the largest bank holding  companies than for smaller bank holding companies and (2) the  size of funding cost differences in 2013.  In addition, we amended  the draft to clarify that our results for the hypothetical scenario for  2013 differ from our results for 2008, in which all 42 models  predicted lower funding costs for larger bank holding companies.
Treasury and the Federal Reserve Board provided comments  related to the draft report’s presentation of statistical significance  in figures 1, 2, and 3. In response to these comments, we made  formatting changes to the figures to more clearly differentiate  estimates that are statistically significant from those that are not.
In addition, we note that table 7 on pages 79-81 of the report  contains some of the data used to create figures 1, 2 and 3 and  differentiates between estimates that are statistically significant at  the 1 percent, 5 percent, and 10 percent levels. Finally, while  statistically insignificant estimates may be viewed as weaker  evidence than statistically significant estimates and may influence  how our results are interpreted, we note that statistical  significance is not the only relevant characteristic of an  econometric estimate and that by presenting the full range of  results one can better assess their magnitude and economic  significance.
Treasury and the Federal Reserve Board also commented that in  comparing bond funding costs for large and small bank holding  companies, a bank holding company with $10 billion in assets is  too small to make a meaningful comparison to a bank holding  company with $1 trillion in assets. They commented that a bank  holding company with at least $50 billion in assets would provide a  more relevant comparison for this analysis. While we agree that  bank holding companies with $50 billion in assets may be more  similar to $1 trillion bank holding companies than bank holding  companies with $10 billion in assets, we used a smaller size for  small bank holding companies because bank holding companies  with $50 billion or more in assets may be viewed by investors as  “large” and systemically important, in part because $50 billion in  assets is the size threshold for Dodd-Frank Act requirements  related to enhanced regulatory standards. While we agree that  bank holding companies of different sizes have different  characteristics, we compared estimated funding costs for bank  holding companies assuming their credit risk and other  characteristics are identical. Finally, increasing the size of the  small bank holding company in our comparisons would not have a  substantive impact on the sign or statistical significance of our  estimated differences in funding costs, nor would it change the  trends in estimated differences in funding costs over time.
The Federal Reserve Board and OCC commented that few of the  estimated coefficients on the variables measuring size and size  interacted with credit risk reported in table 5 were individually  statistically significant, suggesting that there is little statistical  evidence of a relationship between bond funding costs and size.  To address this concern, we conducted hypothesis tests that the  coefficients on the size and size-credit risk interaction terms are  jointly equal to zero. The results of these hypothesis tests suggest  that the coefficients on the size and size-credit risk interaction  terms are jointly significant at the 5 percent level, suggesting that  there is statistical evidence of a relationship between bond funding  costs and size. We report the results of our joint hypothesis tests  in table 5 on pages 74 and 76 of the report. In addition, we note  that the draft report only contains coefficient estimates for the 6  baseline models of the 42 total models for 2008 and 2013 and that  those 6 models are presented as examples and do not fully reflect  the impact of size in all the specifications in those years or in other  years. However, we believe the regression-level detail on the 6  baseline models included in the report is sufficient to assist  readers looking to understand our methodology and conclusions.
OCC suggested that selection bias and omitted variables bias  could reduce the validity of our econometric results. We agree that  these biases are potential limitations of the model and are among  the reasons the results should be interpreted with caution. We  discuss the potential impact of these concerns on pages 56-57.
OCC and FDIC commented on the endogeneity of some  independent variables and the impact this could have on our  results. We agree that endogeneity is a potential limitation of the  model and is among the reasons the results should be interpreted  with caution. In response to this comment, we added a paragraph  discussing the potential impact of endogeneity on our results on  page 57 of the report.
We are sending copies of this report to FDIC, the Federal Reserve Board,  FSOC, OCC, Treasury, interested congressional committees, members,  and others. In addition, the report is available at no charge on the GAO  website at http://www.gao.gov.
If you or your staffs have any questions regarding this report, please  contact me at (202) 512-4802 or EvansL@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix III.
section_title: Appendix I. Methodology for Analysis of Funding Cost Differences between Large and Small Bank Holding Companies
paragraphs: To assess the extent to which the largest bank holding companies have  received funding cost advantages as a result of perceptions that the  government would not allow them to fail, we conducted an econometric  analysis of the relationship between a bank holding company’s size or  systemic importance and its funding costs. Bank holding companies  obtain funds from investors—such as depositors, creditors, or  shareholders—which they use to finance assets, such as various types of  credit. The prices that bank holding companies pay to obtain these funds  are influenced by several factors, including credit risk—the likelihood that  bank holding companies will repay the funds they borrowed as agreed— and other factors. Funding cost advantages may arise if investors believe  that the government is more likely to support larger bank holding  companies in distress than smaller bank holding companies in distress.  This belief may lead investors to view larger bank holding companies as  having less credit risk than smaller bank holding companies and thus  charge larger bank holding companies a lower price to borrow than  smaller bank holding companies.
We used a multivariate regression model to estimate the relationship  between bank holding companies’ funding costs and their size while  controlling for factors other than size that may also influence funding  costs. Our general regression model is the following:  In this model, 𝑏 denotes the bank holding company, 𝑞 denotes the  quarter, 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑏𝑞 is the bank holding company’s cost of funding in  a quarter, 𝑠𝑖𝑧𝑒𝑏𝑞 is a measure of the bank holding company’s size at the  beginning of the quarter, 𝑐𝑟𝑒𝑑𝑖𝑡 𝑟𝑖𝑠𝑘𝑏𝑞 is a list of proxies for the bank  holding company’s credit risk, 𝑋𝑏𝑞 is a list of other variables that may  influence funding costs, 𝜀𝑏𝑞 is an idiosyncratic error term, and 𝛼,𝛽,𝛾,𝛿,  and Θ are parameters to be estimated. The parameter 𝛽 captures the  size. The parameter 𝛿 captures the indirect relationship between a bank  direct relationship between a bank holding company’s funding cost and its  holding company’s funding cost and its size that exists if the size of a  bank holding company affects the relationship between its funding cost  and credit risk. If greater values of the size measure are associated with  larger bank holding companies, if greater values of the credit risk proxies  are associated with greater credit risk, and if investors view larger bank  holding companies as less risky than smaller bank holding companies  due to beliefs that the government is more likely to rescue larger bank  holding companies in distress, then either 𝛽 is less than zero, 𝛿 is less  than zero, or both. However, the parameters 𝛽 and 𝛿 may also reflect  factors other than these beliefs.
We used a measure of funding costs based on bonds issued by bank  holding companies that is available for bank holding companies with a  wide variety of sizes. Bank holding companies use a variety of funding  types from different sources, including various types of deposits, bonds,  and equity. We used bond yield spreads—the difference between the rate  of return on a bond and the rate of return on a Treasury bond of  comparable maturity to measure a bank holding company’s cost of bond  funding. Treasury securities are widely viewed as a risk-free asset, so the  yield spread measures the price that investors charge a bank holding  company to borrow to compensate them for credit risk and other factors.  We focused on bond funding costs for several reasons. First, bonds are  traded in secondary markets, so timely information about changes in their  yield spreads, which reflect investors’ perceptions of the credit risk of the  bond’s issuing bank holding company, is easily observable. In contrast,  some uninsured deposit products are not traded in secondary markets, so  changes in the prices of those deposits, which may reflect depositors’  perceptions of the riskiness of the bank holding company, may be less  easy to observe. Second, bond yield spreads are a direct measure of  bank holding companies’ funding costs. In contrast, credit ratings are  indirect measures of bank holding companies’ funding costs because  funding costs can vary for firms with the same rating. Similarly, total  interest expense as reported on a bank holding company’s balance sheet  is an imperfect measure of funding costs because total interest expense  may aggregate the prices of liabilities with many important differences,  including term and creditor priority. Third, bonds generally rank higher in a  bank holding company’s capital structure than equity, so bondholders are  less likely to suffer losses and more likely to be repaid if a bank holding  company becomes distressed. Bondholders are thus more likely to  benefit if a distressed bank holding company is rescued by the  government. In contrast, equity holders generally rank lowest in a bank  holding company’s capital structure and are the first to suffer losses if a  bank holding company becomes distressed. Shareholders are thus the  least likely to benefit if a distressed bank holding company is rescued by  the government. It follows that the cost of bond funding is more likely to  reflect investors’ beliefs about the likelihood of government support than  the cost of equity funding. Fourth, bank holding companies with a wide  variety of sizes issue bonds, including some with less than $10 billion in  assets. In contrast, credit default swaps—the prices of which likely reflect  perceptions of a bank holding company’s credit risk—are available for  only a small number of large bank holding companies.
We used Bloomberg to identify U.S. bank holding companies with more  than $500 million in assets that were active in one or more years from  2006 to 2013, and to identify all plain vanilla, fixed-rate, senior unsecured  bonds issued by these bank holding companies, excluding bonds with a  government guarantee. companies and bonds we analyzed.
section_title: Appendix II: Comments from the Department of the Treasury
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments:
paragraphs: In addition to the contact named above, Karen Tremba (Assistant  Director), John Fisher (Analyst in Charge), Bethany Benitez, Michael  Hoffman, Risto Laboski, Courtney LaFountain, Rob Letzler, Marc Molino,  Jason Wildhagen, and Jennifer Schwartz made significant contributions to  this report. Other assistance was provided by Abigail Brown, Rudy  Chatlos, Stephanie Cheng, and José R. Peña.
section_title: Bibliography
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