Goldman Says, What Too Big to Fail Advantage?

NEW YORK ( TheStreet) -- Goldman Sachs has published a paper that debunks the idea that the biggest banks get an unfair funding advantage because they are considered "too big to fail"

The firm's public policy research unit, the Global Markets Institute, said in a May report titled "Measuring the TBTF effect on bond pricing" that recent studies overstate the funding advantages of so-called Too Big to Fail Banks.

According to the researchers' findings, the big banks enjoyed a slight funding advantage of about 6 basis points on an average between 1999 and 2007, which widened sharply during the crisis but has now reversed to a "disadvantage."

Bonds of the biggest six banks -- JPMorgan Chase ( JPM), Bank of America ( BAC), Citigroup ( C), Wells Fargo ( WFC), Goldman Sachs ( GS) and Morgan Stanley ( MS) actually trade at a 10 basis point disadvantage to the bonds of other banks, according to the research report.

Their findings strike at the heart of the debate surrounding the country's biggest banks. Several studies published recently have found that the biggest banks get a "taxpayer driven funding advantage" over smaller banks, because the market believes the government will not risk harm to the financial system by allowing these large banks to fail.

The belief that some banks are too big to fail is dangerous as it could once again lead to reckless risk taking, as some players may believe that the losses will always be "socialized." It is a notion that regulators and policymakers want to get rid of and has prompted serious calls to break up the big banks.

But those studies have tended "to analyze an overly broad universe of bond issuers, including non-bank financials and non-US firms from a wide range of countries," the Goldman Sachs researchers wrote. The broader universe had the effect of inflating the advantage of the largest banks, according to Goldman.

While some studies have said the advantage might be as much as 80 basis points, Goldman Sachs researchers say the advantage since 1999 has averaged 31 basis points.

Moreover, the other studies ignored the fact that the biggest firms in most industries, not just banking, have a funding advantage over smaller ones. In fact the advantage in other industries was even greater than that observed in banking, according to Goldman.

The researchers said funding advantages for the largest banks was justified. "We find that the bonds of the largest banks provide investors with far greater liquidity, and that this added liquidity can in itself explain the funding advantage that the largest banks have at times experienced," they wrote.

Big banks enjoy a funding advantage not because of implied government support but because investors want to "pay for the benefits of liquidity," and this pattern is evident across almost all industries.

Moreover, "large firms are easier to recapitalize than small firms," Goldman's researchers wrote, leaving bond investors with fewer losses when the big firms encounter trouble. So they are willing to pay a premium for bonds of bigger banks.

For instance, according to Goldman Sachs, the government made a 15% profit on assistance to the six largest banks and diluted shareholders by 5% to 82%. In contrast, more than 400 small banks are yet to fully repay TARP and 40% of those that have repaid have relied on other sources of government funding, rather than their own resources.

Based on their findings, the researchers concluded that the policy debate on Too Big to Fail needs to focus less on subsidies and more on working out a resolution to ensure that the government can impose losses of a big bank failure on shareholders and bond investors, reducing the economic fall-out from large bank failures.

-- Written by Shanthi Bharatwaj in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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