BY ROB COX

The biggest question left unanswered since the great financial crisis erupted 10 years ago is the following: Are some banks too big to fail? It can’t be solved because no major U.S. financial institution has come close to collapsing in the decade that followed Lehman Brothers’ failure. Only a true calamity, the conventional wisdom goes, will test the mettle of watchdogs, central bankers and politicians.

Naysayers argue that, when push comes to shove, the political and regulatory establishment will cave, resorting to variations on the taxpayer bailouts that limited catastrophes in the United States, UK and other developed economies in 2008. Supporters of reforms like the Dodd-Frank Act say the system is safer and that creditors and stockholders will bear the burden of even a mega-bank’s demise.

It’s hard to say who is right. But for first time since before things went wobbly there is some evidence to suggest one feature of the era of too-big-to-fail banks is at last coming to an end – at least in the world’s largest banking market. So far it is just a scintilla of proof contained in a recent data dump from the Federal Deposit Insurance Corp relating to the way large and small banks fund themselves.

Every quarter, the watchdog conducts an extensive crunch of numbers from all the banks whose deposits it insures. At last count, at the end of June, that came to 5,542 separate entities, a number that has shrunk every year since peaking in 1986 at more than 18,000 institutions. Back then, there were no banks with trillion-dollar balance sheets like JPMorgan, Wells Fargo or Bank of America. The 38 biggest banks, all with less than $250 billion in assets, made 28 percent of all the industry’s loans.

Over the years, through mergers and acquisitions, failures, and regulator-supervised consolidation, that has shifted dramatically. Today just nine banks control half of the entire industry’s assets. This cohort, which also includes Morgan Stanley, Goldman Sachs and Citigroup, is what regulators call systemically important – meaning they are deemed so big that the demise of just one of them might bring down the whole financial order. That’s why they received the bulk of the taxpayer-funded bailout made available during the 2008 panic.

Even though the subsequent financial reforms passed by Congress mandated they wouldn’t receive that sort of preferential treatment again, these big banks have financially benefitted from a lingering perception that they will never be allowed to go under. It is visible in what the FDIC calls their “quarterly cost of funding earning assets.” This is effectively what the banks pay for the money they use to make loans to borrowers, or to purchase interest-bearing securities like Treasury bonds.

Naturally, banks with lower funding costs should be more profitable because the difference widens between what they pay for money from depositors and investors, and what they charge for lending. Banks that do not let that so-called spread fall to the bottom line can use it as a competitive edge in the hunt for customers, undercutting banks that pay more to fund their earning assets.

For most of the contemporary history of American banking, at least as tracked by the FDIC since 1984, being bigger had no discernible benefit when it came to funding costs. Consider the first quarter of 1986, when America had a record 18,083 banks. The biggest of them, on aggregate, paid 7.59 percent to fund their businesses. Everyone else paid less, with the smallest fries paying a full percentage point less.

Apart from a few quarters in the early part of this century, that dynamic remained relatively consistent until the first cracks in the subprime mortgage market emerged. At the start of 2008, the top six banks started paying lower funding costs, at first by just a few basis points. But as the U.S. government stepped in to prop up the largest firms, that gap dramatically widened.

At the start of 2009, the six banks with balance sheets greater than $250 billion were paying just 1.06 percent to fund their assets, according to the FDIC. The 4,504 banks with between $100 million and $1 billion of assets – the largest category by number of institutions – were suddenly paying double that. The reason: Depositors and investors appeared to believe the big banks would not be allowed to fail, so their money was safer in the vaults of a JPMorgan, Bank of America or Wells Fargo.

Big bank executives made up all sorts of other reasons for the widened funding gap. It was, they argued, because big banks had vast branch and ATM networks; their mobile applications were superior; younger customers don’t want personalized customer service; and so on and so forth.

In effect, it was something like a run on the small- and medium-sized banking industry. And the disparity continued, beyond the passage of Dodd-Frank, the rollout of new capital standards and the Volcker Rule prohibiting proprietary trading. It outlasted even the era of ultra-low official interest rates.

Until now. In the most recent quarter analyzed by the FDIC, banks with fewer than $1 billion of assets paid 0.63 percent to fund their books, 1 basis point less than the nine mega-banks. That hasn’t happened since the end of 2007. The trend began with the smallest cohort of banks in the first quarter.

There are a few possible explanations. Big banks face more competition, and are therefore quicker to raise rates on interest-bearing deposits as the Federal Reserve increases the official cost of money. Customers of smaller banks, many of which are in rural communities, may have fewer choices and anyway may prize more personalized service. Perhaps, but one hopeful interpretation may be that, 10 years after the chaos, the market has come to believe that all banks can fail in equal measure.

Sheila Bair, who ran the FDIC during the crisis, thinks regulators have the tools they need to allow for large institutions to go under without impeding customers seeking mortgages or small business loans. “You impose losses on the shareholders and creditors, which is how it’s supposed to work,” she told Breakingviews in the Exchange podcast to be aired later this month. “But I think you also have the problem of just too big, and too big in terms of political influence, too big an influence of your academic institutions, too big in terms of influence over think tanks, too big, frankly, an influence over some of the media.”

The numbers are moving in the right direction, one where size no longer appears to confer a specific too-big-too-fail advantage. But only the next crisis will confirm whether she’s right on the politics.

First published Sept. 11, 2018

(Image: REUTERS/Mike Segar)