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: This testimony summarizes the information contained in GAO's Month Year report, entitled Large Bank Holding Companies: Expectations of Government Support, GAO-14-621 .
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.

section_title: Letter
paragraphs: I am pleased to be here today to discuss the results of our report on  expectations of government support for large bank holding companies. As  you know, “too big to fail” is the term commonly used to refer 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. 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.
My remarks today are based on our report, released at this hearing,  entitled Large Bank Holding Companies: Expectations of Government  Support. As you know, this is the second of two reports we are issuing  on the topic of 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.  Accordingly, this testimony discusses (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.
To conduct this work, we reviewed relevant statutes and rules and  interviewed regulators, bank holding companies, rating agencies,  investment firms, and corporate customers of banks. We also reviewed  relevant studies and interviewed authors of these studies. Finally, we  conducted quantitative analyses to assess potential “too-big-to-fail”  funding cost advantages. Our work for the report on which this statement  is based was conducted in accordance with generally accepted  government auditing standards. Further details on our scope and  methodology are included in the report.
In summary, we found that while views varied among market participants  with whom we 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. Our  analysis 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. While there were notable  exceptions, most models suggest that such advantages may have  declined or reversed. For example, most models we estimated suggest  that large bank holding companies had higher bond funding costs than  smaller bank holding companies in 2013. However, the outcomes of our  econometric models varied with the choice of variables we used to  capture size, credit risk, and bond liquidity, and some still predicted a  funding cost advantage for larger banks in 2013. Moreover, in  hypothetical scenarios in which the level of credit risk in every year from  2010 through 2013 is assumed to be as high as it was in 2008 during the  crisis, most of our models suggest that bond funding costs for larger bank  holding companies would have been lower than those for smaller bank  holding companies in most years during this period. Given the nature of  this analysis and associated limitations, our results should be interpreted  with caution. Changes over time in our estimates of the relationship  between bond funding costs and size may reflect changes in investors’  beliefs about 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. However, we cannot precisely identify the  influence of each of these factors. In addition, our estimates may also  reflect differences in the characteristics of bank holding companies that  do and do not issue bonds or factors we have not captured in our model.  Finally, our estimates are not indicative of future trends.
subsections: section_title: Views of Key Market Observers on Recent Regulatory Reforms
paragraphs: U.S. federal financial regulators have made progress in implementing  provisions of the Dodd-Frank Wall Street Reform and Consumer  Protection Act (Dodd-Frank Act) and related reforms to restrict future  government support and reduce the likelihood and impacts of the failure  of a systemically important financial institution (SIFI). These reforms can  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.
We found that while views varied among market participants with whom  we 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. Citing recent  reforms, two of the three largest credit rating agencies reduced or  eliminated “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. Credit rating  agencies and large investors cited the new Orderly Liquidation Authority,  which gives the Federal Deposit Insurance Corporation new authority to  resolve large financial firms outside of the bankruptcy process, 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 to the extent that these expectations affect  decisions by investors, counterparties, and customers of these firms. For  example, market beliefs about government support could benefit a firm by  lowering its funding costs to the extent that 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. Second, higher  credit ratings from assumed government support can benefit firms  through private contracts that reference credit ratings such as derivative  contracts that tie collateral requirements to a firm’s credit rating. Finally,  expectations of government support can affect a firm’s ability to attract  customers to varying degrees.
New and higher fees imposed by the Dodd-Frank Act, stricter regulatory  standards, and other reforms could increase costs for the largest bank  holding companies relative to smaller competitors. Officials from the  Financial Stability Oversight Council (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.  According to Department of the Treasury (Treasury) officials, key areas  that require continued progress include education of market participants  on reforms and international coordination on regulatory reform efforts,  such as creating a viable process for resolving a failing financial institution  with significant cross-border activities.
section_title: Analysis of Funding Cost Differences between Large and Small Banks
paragraphs: We 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, we 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 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 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. In addition, studies that pooled a large number  of countries in their analysis have results that may not be applicable to  U.S. bank holding companies and studies that did not include data past  2011 have results that may not reflect recent changes in the regulatory  environment.
Our 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.
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, such as bank holding company credit risk. Key features of our  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—the difference  between the yield or rate of return on a bond and the yield on a  Treasury bond of comparable maturity—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 global  systemically important bank 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 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, 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. In contrast, some of the studies we reviewed estimated a  more limited number of model specifications.
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 those 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 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 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. Circles and 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.  For example, for 2013, a total of 18  models predicted statistically significant differences above zero and a  total of eight models predicted statistically significant differences below  zero.
Our analysis provides evidence that the largest bank holding companies  had lower funding costs during the 2007-2009 financial crisis but that  these differences may have declined or reversed in recent years.  However, we found that the outcomes of our econometric models varied  with the various controls we used to capture size, credit risk, and bond  liquidity. This variation indicates that uncertainty related to how to model  funding costs has an important impact on estimated funding cost  differences between large and small bank holding companies. As figure 1  shows, most models found that larger bank holding companies had lower  bond funding costs than smaller bank holding companies during the  2007-2009 financial crisis, but the magnitude of the difference varied  widely across models, as indicated by the range of results for each year.  For example, for 2008, our models suggest that bond funding costs for  bank holding companies with $1 trillion in assets and average credit risk  were from 17 to 630 basis points lower than bond funding costs for similar  bank holding companies with $10 billion in assets.
Our models’ comparisons of bond funding costs for different-sized bank  holding companies for 2010 through 2013 also vary widely. For bank  holding companies with average credit risk, more than half of our models  suggest that larger bank holding companies had higher bond funding  costs than smaller bank holding companies from 2011 through 2013, but  many models suggest that larger bank holding companies still had lower  bond funding costs than smaller ones during this period. For example, for  2013, our models suggest that bond funding costs for average credit risk  bank holding companies with $1 trillion in assets ranged from 196 basis  points lower to 63 basis points higher than bond funding costs for similar  bank holding companies with $10 billion in assets (see fig. 1). For 2013,  30 of our models suggest that the larger banks had higher funding costs,  and 12 of our models suggest that the larger banks had lower funding  costs.
To assess how investors’ beliefs that the government will support failing  bank holding companies have changed over time, we compared bond  funding costs for bank holding companies of various sizes while holding  the level of credit risk constant over time at the average for 2008—a  relatively high level of credit risk that prevailed during the financial crisis.  In these hypothetical scenarios, most models suggest that bond funding  costs for larger bank holding companies would have been lower than  bond funding costs for smaller bank holding companies in most years  from 2010 to 2013. For example, most models for 2013 predict that bond  funding costs for larger bank holding companies would be higher than for  smaller bank holding companies at the average level of credit risk in that  year, but would be lower at financial crisis levels of credit risk (see fig. 2).  These results suggest that changes over time in funding cost differences  we estimated (depicted in fig. 1) have been driven at least in part by  improvements in the financial condition of bank holding companies. At  the same time, more models predict lower bond funding costs for larger  bank holding companies in 2008 than in 2013 when we assume that  financial crisis levels of credit risk prevailed in both years, which suggests  that investors’ expectations of government support have changed over  time. However, it is important to note that the relationships between  variables estimated by our models could be sensitive to the average level  of credit risk among bank holding companies, making these estimates of  the potential impact of the level of credit risk from 2008 in the current  environment even more uncertain. Moreover, Dodd-Frank Act reforms  discussed earlier in this statement, such as enhanced regulatory  standards for capital and liquidity, could enhance the stability of the U.S.  financial system and make such a credit risk scenario less likely.
This analysis builds on certain aspects of prior studies, but 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. Our estimates of differences in funding costs  reflect a combination of several factors, including investors’ beliefs about  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 components. 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. 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. 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. Finally, our estimates are not indicative of future  trends.
After reviewing the draft report, Treasury provided general comments and  Treasury, FDIC, the Federal Reserve Board, and OCC provided technical  comments. In its written comments, Treasury commented that our draft  report represents a meaningful contribution to the literature 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 found 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, 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 factor with  certainty. In addition, Treasury and other agencies provided via email  technical comments related to the draft report’s analysis of funding cost  differences between large and small bank holding companies. We  incorporated these comments into the report, as appropriate. A complete  discussion of the agencies’ comments and our evaluation are provided in  the report.
Chairman Brown, Ranking Member Toomey, and Members of the  Subcommittee, this concludes my prepared remarks. I would be happy to  answer any questions that you or other Members of the Subcommittee  may have.
section_title: GAO Contacts
paragraphs: For future contacts regarding this statement, please contact Lawrance L.  Evans, Jr. at (202) 512-4802 or at evansl@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found  on the last page of this statement. Other GAO staff who made significant  contributions to this statement and the report it is based on include: 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. Other  assistance was provided by Abigail Brown; Rudy Chatlos; Stephanie  Cheng; and José R. Peña.
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