Pamplin professor testifies how 'too-big-to-fail' doctrine hurts financial markets
Ongoing implicit guarantees of government assistance for the nation’s “too-big-to-fail” banks and financial businesses have a significant effect on financial markets that has amounted to hundreds of billions of dollars, says Deniz Anginer, assistant professor of finance in Virginia Tech’s Pamplin College of Business.
This is the case despite the Dodd-Frank Act of 2010, which was passed to end government bailouts, says Anginer, who teaches at Virginia Tech's National Capital Region location.
Anginer made these statements when called as a witness before a subcommittee of the U.S. Senate Committee on Banking, Housing, and Urban Affairs in a hearing on July 31. The hearing examined a report by the General Accounting Office on the expectations of government support for bank holding companies.
“’Too big to fail’ is one of those issues where everyone agrees something must be done, but approaches to dealing with the problem vary — sometimes dramatically,” says Anginer.
The controversial doctrine “holds that the government will not allow large financial institutions to fail if their failure would cause significant disruption to the financial system and economic activity,” he says. “Today, expectations of government support among large financial institutions and their investors continue virtually unabated since the Great Recession of 2008.”
Subcommittee chair Senator Sherrod Brown (D-OH) invited Anginer to testify at the hearing in view of a related study he had co-authored. In his testimony, Anginer mentioned specific ways in which the doctrine has a negative impact on financial markets. One impact is that the price of bonds that too-big-to-fail companies issue reflects expectations that the government will back their debts, allowing them to borrow at lower rates than small to mid-size competitors.
Too-big-to-fail status also distorts how debt prices reflect risk. “An implicit government guarantee dulls market discipline by reducing investors’ incentives to monitor and price the risk-taking of large financial institutions,” Anginer told his audience, which comprised senators, lobbyists, and the financial press.
“In our analyses, we show that while a positive relationship exists between risk and cost of debt for medium and small-sized institutions, this relationship is 75 percent weaker for the largest institutions. Changes in leverage and capital ratios are, likewise, less sensitive to changes in risk for these large institutions.”
The implicit guarantee gave too-big-to-fail institutions an average funding cost advantage of approximately 30 basis points per year from 1990 to 2012, peaking at more than 100 basis points in 2009. The total value of the subsidy amounted to about $30 billion per year on average over the 1990-2012 period, topping $150 billion in 2009.
Anginer and his colleagues posit that despite its no-bailout pledge, the Dodd-Frank Act leaves the door open to future too-big-to-fail bailouts: the Federal Reserve could disguise a bailout by offering a broad-based lending option to a group of financial institutions; Congress could amend or repeal the law; Congress could also allow regulators great leeway that would protect large financial institutions and their creditors.
Anginer closed his testimony by calling for greater governmental transparency.
“Implicit guarantees lack the transparency and accountability that accompany explicit policy decisions," he said. "Taxpayer interests could be better served, in both good times and bad, by estimating on an ongoing basis the accumulated value of this subsidy. Public accounting of accumulated too-big-to-fail costs might restrain those government actions and policies that encourage bailout expectations.”
Anginer based his testimony on the article, “The End of Market Discipline? Investor Expectations of Implicit Government Guarantees,” which he coauthored with Viral V. Acharya, of New York University, and A. Joseph Warburton, of Syracuse University. Read the full text of his testimony.
Anginer was a financial economist at the World Bank’s development research group before joining Pamplin. His research has been featured in the media, including the New York Times and Bloomberg Businessweek.