Below is the big GAO report on too big to fail, we will be following up with more analysis. For now see what Brown and Vitter said about the report, also AFR sent ValueWalk the following statement:

AFR Statement on GAO Report

Over the past two years a wide variety of respected sources, including the International Monetary Fund, the New York Federal Reserve, and numerous academics have found that large bank holding companies have enjoyed a funding advantage over smaller banks due to the continuing perception that these companies would receive significant public support to prevent their failure.

The study released today by the General Accounting Office once again finds clear evidence that these funding advantages existed over the 2006-2011 period, and would in general be expected to exist during periods of elevated credit risk. However, the GAO’s statistical exercise did not find clear evidence for the continued existence of a ‘too big to fail’ funding advantage in 2013. Some of the models they tested did find such a funding advantage, but more did not.

AFR does not believe that this finding should be read as evidence that the problem of ‘too big to fail’ has been solved.  First, one would expect any funding advantage due to government support to decline during periods where perceptions of credit risk generally in the markets was low. Credit spreads have reached unusually low levels over the past few years.  Consistent with this, the GAO analysis predicts that should credit risk perceptions increase, the funding advantage for large banks would reappear.  Second, the GAO found that market participants they interviewed believe that implementation of the Dodd-Frank Act so far has reduced, but not eliminated the likelihood that the federal government would step in to prevent any of the largest bank holding companies from failing.   Third, regulators themselves have stated that the implementation of the Dodd-Frank resolution mechanism is not yet adequate to end the possibility of government support to large banks. Finally, other potential bailout mechanisms, such as Federal Reserve emergency lending, are not yet subject to adequate controls.

GAO report below

What GAO Found

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

GAO Bond funding

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

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