Too Big to Fail Causes, Consequences and Policy Responses

Philip E. Strahan

Annual Review of Financial Economics Conference

October, 2013 Too Big to Fail is a credibility problem

 Markets expect creditors to be bailed out when  Borrower is large  Borrower is financial and relies on short‐term debt  Borrower is inter‐connected  Promises to eschew bailouts are not fully credible

 Credit market distortions  Bond yields don’t fully reflect risk  Weakens incentives to monitoring, enforce margin, impose haircuts, etc. Why do markets expect bailouts?  Short‐run spillovers may outweigh long‐run costs of bailouts  Liquidation of financial institutions is costly  Large failure may cause contagious panics (‘liquidity spirals’)  Declines in money & credit  Large costs to non‐financial sector

 Government agents may prefer bailouts  Political pressure correlated with size  High short‐run costs of financial disruptions  (whereas bankrupt airline still flies jets) Four distortions for TBTF borrowers  Too much leverage (since debt is cheap)  Too much risk (since risk not fully priced & leverage increases risk‐taking incentives)  Distortion propagates to non‐financial firms  Financial firms grow inefficiently large  To capture subsidy  Small firms competitively disadvantaged Fannie & Freddie: Paradigms of TBTF Distortions  Cheap debt  Lack of risk pricing (near Treasury Rates)  Highest leverage among all US financial firms  Increasingly aggressive investment in risky mortgages during the 2000s  Rapid (and unsustainable) growth in 1990s and 2000s  Other institutions unable to compete in mortgage guarantee business What Do We know from the Empirical Literature?  Borrowing costs are lower and less risk‐sensitive for large banks  But also true for large non‐financials  Large banks have more leverage & take more risk than smaller ones  But large banks are also better diversified than smaller ones  Are large banks less efficient than small ones?  Mixed evidence from cost studies of banks  Some evidence that bank M&As motivated by desire to become very large TBTF Problem has varied over time  Continental Illinois (1980s)  Comptroller admits some banks are ‘too big to fail’  Wealth increases at large banks, less risk pricing in debt markets  FDIC Improvement Act (1990s)  Least cost resolution  More risk pricing in bank debt  LTCM (2000s)  Large hedge fund drew Fed attention  No follow up on regulating large institutions  2008 Financial Crisis (2010 and beyond) Did TBTF cause the Financial Crisis?  Proximate cause: A run on the shadow banking system  But TBTF likely helped sow seeds of the run  Increased leverage in 2000s  Off balance‐sheet leverage (OTC derivatives)  Increase in securitization without risk transfer  Increase in origination of risky loans  Subprime, leveraged loans, covenant lite, etc.  And little‐to‐no risk pricing at largest banks  Graph of CDS CDS Spreads for Top 10 Banks, 2004 to 2006

1.00%

0.80%

0.60%

0.40%

0.20%

0.00% 2005 2005 2005 2005 2005 2005 2005 2005 2005 2005 2005 2005 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2006 2006 2006 2006 2006 2006 2006 2006 2006 2006 2006 2006 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jul Jul Jul Jan Jan Jan Jun ‐ Jun Jun Sep Feb ‐ ‐ Sep Sep Apr Oct Feb Feb Oct Apr Oct Apr Dec ‐ Dec Aug Dec Mar Nov ‐ ‐ Aug Aug ‐ Mar Nov 1 Mar Nov May ‐ ‐ 1 1 ‐ May May ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ 1 ‐ ‐ ‐ 1 ‐ 1 ‐ ‐ 1 ‐ ‐ ‐ ‐ ‐ 1 ‐ ‐ 1 1 ‐ 1 1 1 ‐ 1 ‐ 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

Mean Range Is TBTF Getting Worse?  Greater importance of finance to the economy  Credibility problem has its roots in concern about spillovers  Greater concentration in the financial and banking system  Morgan+Bear+WaMu  Bank of America+Countrywide+Merrill Lynch  Wells Farg0+Wachovia Finance value‐added increasing: Finance / GDP (%)

0 Concentration increasing: Top‐10 Bank Share

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0.00 But post‐crisis adjustments have made system more robust  More Capital  More Liquidity  More Stable Funding  Less Off‐Balance Sheet Leverage Capital ratios have increased at large banks

9.50%

9.00%

8.50%

8.00%

7.50%

7.00%

6.50% 2000 2003 2006 2009 2012 Large banks hold more cash

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00% 2 2 2 2 2 2 2 2 2 2 2 2 2 2 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 0 1 2 3 4 5 6 7 8 9 0 1 2 3 More stable funding: Deposit/assets at large banks

75.0%

73.0%

71.0%

69.0%

67.0%

65.0%

63.0%

61.0%

59.0%

57.0%

55.0% 2000 2003 2006 2009 2012 Have expectations of bailouts have declined?  CDS Markets now price large‐bank risk  Natural experiment: Removal of TAG at the end of 2012  Money flowed into small banks (not large one) CDS Spread pre‐ v. post‐crisis, Top 10 banks

5.00%

4.50%

4.00%

3.50%

3.00%

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%

Median Interquartile Range Changes in Transactions Deposits with the Expiration of TAG (Kroszner, 2013)

7% 6.1% 6% 5% 4% 3% 2% 1% 0.3% 0% -1% -0.4% GSIB CCAR (excluding GSIB) Other banks Conclusion  TBTF rooted in hard‐to‐solve credibility problem  Markets rationally expect large, interconnected banks to be bailed out  Expectations of bailouts are not static  High in the 1980s, lower in the 1990s, higher in 2000s  Post‐crisis  Financial system is stronger  And expectations of bailouts seem diminished  New tools to deal with distress  Political pressure not to bailout (Tea Party)  Fiscal pressures (too big to save?) THANK YOU!