WASHINGTON (The Deal) -- The largest financial institutions maintain a too-big-to-fail advantage and should be required to hold "bail-in" capital to ensure their failure won't disrupt the economy, according to studies released Tuesday by the Federal Reserve of New York.
The New York Fed released 11 papers finding that banks have become more organizationally complex and that bond investors provide an additional discount to the largest banks, a situation that one study said is consistent with the idea that investors perceive the largest banks to be too big for the government to let fail should they be near financial collapse.
The papers come as lawmakers and regulators grapple with what to do about the largest financial institutions more than five years after several of them drove the U.S. and global economy into a massive financial crisis that is still echoing in the markets. Some lawmakers have been pushing to impose size limits on the biggest banks - essentially forcing them to break up - while regulators have responded with tougher capital and leverage limits.
However, one study cautioned that imposing limits on the size of big banks would increase the cost of providing banking services - a drawback that must be weighed against the potential "financial stability" benefits of limiting firm size. The study noted that imposing a limit on the size of big banks of no more than 4 percent of GDP, as some have suggested, would increase total banking industry's noninterest expense by $2 billion to $4 billion a quarter.
"Limiting the size of banking firms could still be an appropriate policy goal, but only if the benefits of doing so exceeded the attendant reductions in scale efficiencies," the study said.
Another study found evidence to suggest that certain big banks engage in riskier lending activities, which results in a higher ratio of impaired loans.
Two other studies pressed regulators to set up so-called bail-in regimes, where large financial institutions would be required to issue long-term debt that converts to common equity when a large failing firm is dismantled. The bail-in regime could be employed as part of a new resolution system that was required by the post-crisis Dodd-Frank Act as an alternative to Chapter 11 bankruptcy for big banks.
U.S. regulators have been working on this alternative, known as Orderly Liquidation Authority, which seeks to take apart a failing megainstitution in a manner that its failure doesn't cause Lehman Bros.-like collateral damage to the global markets or require governments to use taxpayer dollars to defend the economy.
The studies argued that bail-in capital would make large bank failures more orderly. One paper "What Makes Large Bank Failures So Messy and What to Do about It?" argued that long-term bail-in debt would reassure holders of uninsured liabilities that their claims will be honored in resolution, making them less likely to run.
In "Why Bail-In? And How!" author Joseph Sommer described bail-in as a "stripped-down form of reorganization working at "warp-speed."
Sommer, who is an assistant vice president and counsel at the Federal Reserve Bank of New York, argued that the bail-in process should create a well-capitalized firm the next morning before the financial liabilities have a chance to run.
"The hope is that this process works as smoothly as a recapitalization with government money - with no government money at risk," Sommer said. "The bonded debt bails out the financial liabilities: hence the sobriquet 'bail-in.' "
The papers were released after Ben Bernanke, in one of his final speeches before stepping down as head of the Federal Reserve, said in January that central bank staffers are reviewing whether big financial institutions should hold "countercyclical capital buffers," a special form of capital that would act like a bond in good times but convert automatically into common equity in a crisis.
However, financial institutions are hesitant to support mandated bail-in capital, even though they acknowledge it could have a positive impact. Bank lobby groups worry that it could make raising bank capital more difficult and expensive, ultimately reducing the amount any institution can lend. Some worry that potential creditors wouldn't want to buy the convertible debt security under any circumstance, knowing that their investment could disappear outright once it is converted into common equity in the middle of a crisis.
Another study, "Evolution in bank complexity," reviewed data over the past 30 years examining consolidation in the banking sphere. It argued that consolidation and diversification led to a significant expansion in complexity at the largest institutions. The study found that banks have gradually expanded into nontraditional banking through acquisitions.
The study also noted that the financial crisis of 2007-09 raised concerns about the very existence of supersized institutions. "Why does society need incredibly large and complex banking institutions when they are a potential cause of systemic disruption?" it asked. "Possible 'subsidies' from explicit or perceived government guarantees may distort incentives in failure resolution."
The paper added that size and complexity may also lead to complicated and ineffective monitoring, such as duplication of rules or regulation that is too strict or too weak.
The papers came as a handful of lawmakers led by Sen. Sherrod Brown, D-Ohio, are seeking to break up the largest banks. So far, the lawmakers' efforts have had no effect except, possibly, contributing to pressure being applied on bank regulators. Regulators haven't taken steps to break up big banks but the Fed and another regulator are seeking to require the biggest federally insured commercial banks to hold 6% of their total assets in capital as part of a leverage ratio, twice that agreed to in a global agreement on bank capital known as Basel III.
"Today, the New York Fed confirmed what regulators and experts of diverse ideologies have been saying: that Wall Street megabanks get advantages due to their 'Too Big to Fail' status," Brown said in a statement. "To add insult to injury, American taxpayers are funding these advantages after many of their megabanks put our economy on the brink of collapse more than five years ago. It's time to level the playing field for all financial institutions and prevent taxpayers from being on the hook for risky megabank practices."