The Big-Bank Subsidy

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

The debate on very large financial institutions has reached an important moment. At the instigation of Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana, the Government Accountability Office is assessing the extent to which big banks and others receive advantages because they have implicit backing from the government.

The stakes are high, as a strong report from the G.A.O. could influence policy. Not surprisingly, representatives of the big banks are pushing back as hard as they can on the notion that they receive subsidies of any kind.

So far, however, this is not going well for the big banks â€" as is made clear in the papers presented at a conference earlier this week at New York University. (I did not attend the conference, but I have reviewed the written material and talked to people who were there. These materials are now on the Web site of the university's Salomon Center.)

A large amount of implicit â€" and explicit â€" government support for some big companies was an undeniable feature of the financial crisis as it developed in fall 2008 and early 2009. For example, Goldman Sachs was helped greatly by being allowed to become a bank holding company in September 2008, as this allowed greater access to funds from the Federal Reserve.

But the big banks assert that these subsidies have been curtailed or perhaps even eliminated by the Dodd-Frank financial reform act of 2010 (see my post on the subject in March). Advocates for the status quo, like the Clearing House, a banking association, consequently say there is no need for any additional policy change â€" like measures that would impose an effective size cap on big banks or require them to be financed with more equity (and therefore less debt) than is the case for smaller companies.

The Clearing House was an organizer of Tuesday's event and helped pick the industry papers, so it is reasonable to see these as the best they can do. Their arguments have three main weaknesses.

First, in the height of the crisis the subsidies (in the form of a huge range of government support) suddenly became apparent â€" and suddenly became very large. This is not contested by the industry; in fact it figures in the Goldman Sachs paper on this topic that I have written about before â€" and that was presented again on Tuesday.

The Goldman Sachs argument is that there are no subsidies today, if you look at the cost of borrowing correctly (so larger financial companies do not borrow more cheaply than smaller ones). I'll come back to what the data show in a moment, but we should not forget that the full scale and nature of these subsidies in 2008 was a surprise to financial markets.

More broadly, markets missed the buildup of risk at some very prominent companies, including Citigroup, which was at the epicenter of what went wrong. What really matters is not what is in the data at a moment of relative calm, but rather what will happen when there is extreme stress.

Second, it is hard to argue that “Dodd-Frank has fixed too big to fail” when implementation of Dodd-Frank has so been slow, in part because of industry opposition.

Paul Saltzman, president of the Clearing House Association, contends that slowing Dodd-Frank implementation with comment letters and other forms of pressure is entirely within the constitutional rights of people employed by the industry. He is completely correct in that regard; there is nothing untoward about opposing public policy positions that you do not like.

But the successful delaying tactics used by big banks make it harder to believe that Dodd-Frank has yet made so much difference.

To take just one example, while the Federal Deposit Insurance Corporation has developed a plan for “resolving” large financial institutions that get into trouble, key details of this approach remain to be determined. The Federal Reserve has not yet decided the funding structure of bank holding companies â€" i.e., how much equity and “loss-absorbing debt” they will need to have (and what exactly “loss-absorbing” means).

The Fed has also not yet determined that the “living wills” of big banks are sufficient to allow them to fail â€" i.e., go bankrupt â€" without resorting to resolution and without disrupting world markets. The F.D.I.C.'s resolution plans are supposed to be a backup, not the first resort.

The industry is opposing changes to the funding structure of holding companies and also the idea that banks should have to change anything about their operations to make bankruptcy more plausible. Five years after the crisis, we still do not know what would happen if one or more systemically important financial companies got into trouble again.

Third, the best evidence developed by independent researchers (i.e., those not employed by the Clearing House or its allies) continues to run strongly in favor of the notion that big subsidies still exist.

For example, I recommend “The End of Market Discipline? Investor Expectations of Implicit State Guarantees,” by A. Joseph Warburton, Deniz Anginer, and Viral V. Acharya, which was also presented on Tuesday. This is sensible work that sifts through the data carefully â€" and that considers what has changed over time. (Professor Acharya was a co-organizer of the event and was most helpful to me in preparing this column, but all the views here are mine alone.)

Their paper finds, “The implicit subsidy provided large institutions an annual funding cost advantage of approximately 28 basis points on average over the 1990-2010 period, peaking at more than 120 basis points in 2009.” This means that large institutions could borrow more cheaply from private lenders, presumably because the implicit government guarantee lowered the credit risk for those firms relative to their smaller competitors. They also find that “passage of Dodd-Frank did not eliminate expectations of government support” - meaning this advantage in credit markets persists in the data.

Another paper, presented by Stijn Van Nieuwerburgh, a finance professor at N.Y.U., uses options data to show that, at the peak of the crisis, the risk that the financial sector would collapse as a whole was substantially underpriced relative to the risk of failure of individual financial firms. This may sound technical but it is actually quite profound; it means the markets expected a rescue of some form at the systemwide level. Nothing comparable is observed in options data for nonfinancial companies. This research, done jointly with Bryan T. Kelly and Hanno N. Lustig, supports the idea that there is a “too systemic to fail” subsidy of some kind (likely to be related to size, at least in part).

Public engagement between the industry and its critics is entirely appropriate. In fact, Columbia University is playing host to a live radio public event on these banking issues on Wednesday, organized by Intelligence Squared U.S., at which Richard W. Fisher of the Federal Reserve Bank of Dallas and I will debate Mr. Saltzman of the Clearing House Association and Douglas J. Elliott, a former investment banker now at the Brookings Institution.

We should, of course, evaluate all arguments on their merits, but it is also not unreasonable to keep in mind a line from Upton Sinclair: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

I strongly recommend that the G.A.O. study the work of Professors Warburton, Anginer and Acharya and of Professors Kelly, Lustig and Van Nieuwerburgh carefully, while assessing the industry arguments with a great deal of skepticism.