The US Government Accountability Office (GAO) released a study last week that looked at US bank funding costs in light of recent financial regulatory reforms. The study showed no 100% conclusive results, but details reveal some helpful suggestions in considering how bank funding costs should be assessed.
The purpose of the study was to understand how large US banks have benefitted from explicit or implicit government support. One of these supports is the idea that a large bank would be saved by the US government in times of significant stress (too big to fail). Following the implementation of Dodd-Frank’s Orderly Liquidation Authority, theoretically the US government is no longer in the bank bail-out business. We’ll see how they may hold true or not at some point in the future. Meanwhile, two of the three ratings agencies have already removed government support (“uplift”) as a factor in their bank evaluations, and the third is likely to do so soon. This means that investors looking to invest in US bank debt should no longer be factoring in government support. The next question is, does taking away government support mean that banks now have higher funding costs? And, all things being equal such as institution size, do large US banks have larger, smaller or the same funding costs as their smaller competitors?
The short answer to the funding question is mixed. The GAO found that bank funding costs in 2007-2009 were undeniably better than the funding costs of smaller competitors. This was a high stress period where the promise of the uplift from government support was definitely a positive for large banks. Moving into the 2011-2013 period, the GAO found that among the 42 models they ran, “more than half of the models found that larger bank holding companies had higher bond funding costs than smaller ones in 2011 through 2013, given the average level of credit risk each year.” This suggests that big banks have lost some of their funding cost advantages over smaller banks, an interesting hypothesis and one that may not seem to make sense in the current market environment, hence our particular interest in the conclusion.
The GAO’s work is based on an econometric model that included the following variables:
- U.S. bank holding companies
- 2006-2013 time period
- Bond funding costs
- Alternative measures of size
- Extensive controls for bond liquidity, credit risk, and other key factors
- Multiple model specifications
- Annual estimates of models
- Link between size and credit risk
The figure below shows the range of outcomes for the 42 models run by the GAO.The important point is the bars below 0 on the graph that show the relative decrease in funding cost advantage over the entire time period.
There is a lot to pick on about this study as there is with most any econometric model that remains untested looking forward. The best models are ones that can predict the future, and we don’t have that certainty with the GAO result at all yet. However, the indication here is that with the removal of government support for a bank default, large US banks have lost some level of relative funding advantage over their smaller competitors. We view this as a good thing for US bank competition. This does not yet translate into an absolute funding advantage, and this may be an important topic of conversation as the US Supplemental Leverage Ratio causes a redistribution of some types of bank funding activity, such as repo, around to different bank competitors.