Too-big-to-fail banks are crushing competition

ScreenHunter_1358 Feb. 21 10.10

Cross-posted from the MARQ Services Blog

Since the global financial crisis, the Basel Committee on Banking Supervision has devised numerous reforms to ensure that taxpayers will never again have to rescue banks teetering on the brink of collapse. Yet despite these moves, explicit and implicit government exposures to banks are substantial and are distorting competition.

Professor Deborah Lucas, distinguished professor of finance at the Massachusetts Institute of Technology’s Sloan Business School notes that explicit and implicit government exposures to banks are huge so the prospective costs and risks are high. She believes that policymaking is distorted because governments fail to recognise those potential costs and risks.

Speaking at the Australasian Finance and Banking conference on systemic risk in Sydney last December, Lucas said US mortgage market risk is still held almost entirely by the government. Early in the crisis, the US government took over The Federal National Mortgage Association, FNMA, commonly known as Fannie Mae, and The Federal Home Loan Mortgage Corporation, known as Freddie Mac, in 2008. In doing so, the government converted two government-sponsored enterprises from private companies with implicit government guarantees into entities that are fully owned by the government and whose losses the government has a legal obligation to absorb, said Lucas.

For those with a deep interest in the subject, the book “Measuring and Managing Federal Financial Risk” from the National Bureau of Economic Research and the University of Chicago Press, edited by Professor Deborah Lucas, contains a number of relevant papers on the topic from highly acclaimed academics.

The underlying concern is that governments, including Australia’s, are not assigning any costs to these call option style guarantees which are not only at great cost to the taxpayer but also at the increase of systemic risk.

In Australia, APRA has recently recognised the existence of Domestic Systematically Important Banks (D-SIBs) in their release of its Information Paper of December 23 2013. This paper perhaps puts the spotlight on assessing the costs and risks of both implied and explicit government guarantees that Australia’s D-SIBs enjoy.

Mòrgij Analytics commissioned research on the topic from John Watson of Margate Financial Research Solutions. The full paper can be found here, but the following is a summary:

  • The introduction of the Financial Claims Scheme, that provides a government guarantee of deposits held in $A with ADIs incorporated in Australia per deposit-holder up to $250,000 as well as to policyholders of general insurance companies, is distorting the structure of household financial decision-making in regard to the relative competitive position of authorised deposit-taking institutions versus other financial market participants in the savings, lending and investment markets.
  • The RBA and APRA have agreed to allow participating Australian ADI’s to partly fulfil the incoming Basel III Liquidity Coverage Ratio by paying a 15 basis point fee for a Reserve Bank committed liquidity facility (CLF) based primarily on the repo of AAA RMBS rather than requiring ADI’s to hold larger amounts of government bonds. The RBA is clearly viewing the CLF as a liquidity facility only and pricing it accordingly with no margin for credit risk. However, as there is no liquid market for RMBS where, an ADI or the RBA can safely and quickly sell RMBS, the facility is really a credit facility and therefore should be priced as such. With the tax-payer subsidised cost advantage to the banks (of taking advantage of the CLF rather than purchasing government bonds) of up to 150 basis points based on current market yields, the annual cost of the subsidy to taxpayers amounts to $4.5Billion.
  • D-SIBs do not pay for the benefits they derive from the market-perceived implicit government support which, as the IMF noted in its report on Australia’s 2012 Financial Sector Assessment Program, include lower funding costs than their competitors. In contrast to their smaller rivals (2nd tier banks, regional banks and the mutual sector), the D-SIBs are now regarded by credit rating agencies and investors alike as “too-big-to-fail”. The D-SIBs get the benefit of credit ratings that have been explicitly lifted two notches higher than would otherwise be the case.
  • In addition to the direct funding cost benefit enjoyed by the D-SIBs because of the implied government guarantee, those banks are particularly aggressive on their internal ratings-based approach (IRB) models for calculating risk weighted assets for residential mortgages. The implied guarantee does not just support the credit rating agencies opinions but also allows the market to ignore the low rate of actual capital held against residential mortgages. Risk weighted assets (RWA) for residential mortgages averages around 16% for the D-SIBs. The implied government guarantee support allows the D-SIBs to improve their return on capital whilst maintaining profit levels.
  • On 23 December 2013, APRA released a framework for D-SIBs, belatedly recognising that there is a market perception that the D-SIBs are too big to fail and that this should not be the reality. Unfortunately the APRA determined 1% higher loss absorbency  (rather than 3% adopted by many other regulators) capital requirement effective from 1st January 2016 that must be met from common equity tier 1 capital for D-SIBs does not sufficiently level out the competitive landscape.
  • The following table provides a high level $ estimate of the annual advantages enjoyed by the D-SIBs at the cost to the taxpayer:
Subsidy Estimated Annualised Dollar Cost
Financial Claims Scheme – absence of ex-ante fee. $0.5Billion
Committed Liquidity Facility – under-pricing of fee. $4.5Billion
Too Big To Fail implicit government guarantee (funding advantage). $2.5Billion
Setting the loss absorbency capital requirement at 1% instead of 3% in line with US, UK and other jurisdictions. $1.8Billion
Aggressive RWA calculations for competitive advantage. $1.8Billion
Aggregate tax payer funded subsidies. $11.1Billion per annum

We make no claims as to the exactness of John Watson’s assessment and neither does he, but the research does highlight the significant annual dollar benefits enjoyed by D-SIBs over their smaller rivals, organisations which may provide equal services and have high quality loan books.

As residential mortgages generally represent the majority of assets of the non D-SIB ADIs, MARQ Services can be used to provide detailed transparent analysis and management of those mortgages so that an organisation can prove to regulators, investors and lenders the high quality of its assets. At the very least could this transparent analysis help us to recognise that Australia’s financial system’s future does not just lie with D-SIBs?

Is this something for the Murray Financial System Inquiry to look at in detail?

Leith van Onselen
Latest posts by Leith van Onselen (see all)


  1. “reforms to ensure that taxpayers will never again have to rescue banks teetering on the brink of collapse.”

    Yeah, right. No mention — of course — of the FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” that the whole G20 signed up to in 2010. The implementation of which APRA has set down as its “main strategic objective” in the Australian Budget 2013-14 Portfolio Budget Statements (p. 134).

    A regime which includes bail-in of depositor savings, a la the Cyprus test-run.

    Oh yes, of course. Silly me. I keep forgetting.

    Savers are not taxpayers.

    • Since I”m sure you’ve looked into this in some detail, I have a question you may be able to offer an opinion on.

      If (/when) the bail-in happens, do you think it will be based on individual bank accounts, or total net savings ?

      Ie: will savings accounts between multiple accounts (say, $50k max in each) avoid any haircut if the minimum amount to qualify is, say, $100k ?

      I wonder if mortgage offset accounts will be considered “savings” ? That could shake things up a bit if they are. 🙂

      • drsmithy,

        I tend to think total net savings. Only for the reason that the IMF (and cronies) have been talking of a 10% “wealth tax” for months now. I have a pile of source doc references on that one if you’re interested, but Google just as good; it’s been widely discussed.

        Yes, hitting mortgage offsets would indeed shake things up!

        EDIT: I would urge the seeking and open-minded reader to dig deeper on the significance of why 10% is the number bandied about. Down the rabbit hole we go….

    • O8red
      Don’t you think a bail in is better than a bail out? The former at least internalises the management of default risk to the bank and those who invest in it/lend to it, leaving taxpayers in general off the hook.

      • Those who lend to the bank (depositors) should assume the risk and bear the consequences of that bank’s management of default risk ? No, that would be management and bond and equity holders, thank you very much. If these banks are truly so systematically important that their failure can only be insured against by the public balance sheet, then they should be nationalised. Alternatively, tax and regulate the living f***ng bejeesus out of them so that bond and equity holders can’t expect oversize returns with no accordant risk.

      • @Spleen: Agreed I think we should at least have Commonwealth Bank go back to being what it was including being the reserve bank for Australia, like before the RBA Act was passed.

        Either way Howards looting was effectively a gift to the boomers/superannuation funds and did very little for competition in the sector (read did SFA)

      • @Pat20,

        I agree with spleenblatt. Management, bond and equity holders = “yes”. Depositors = “No”. And I do not say that out of self-interest; I only keep sufficient cash in the bank to manage immediate cashflow needs.

        I know the argument (ie, justification) made, is that depositors are lending to the bank (ie, taking a risk). My objection to this (disgusting, morally bankrupt) rationalisation is simple.

        The population has, over decades — and especially due government policy in the GFC, viz. depositor guarantees etc — been steadily brainwashed into believing that bank deposits ARE safe. Not at risk.

        To then turn around and steal their savings, after leading everyone to believe that the banks are “best in the world”, “safe as houses”, etc etc — no matter the theoretical rationale — is in my view utterly wrong.

        Moreover, it is utterly futile, as stealing savings to “resolve” an insolvent bank/s won’t fix the fundamental problems the world faces anyway.

      • OK, so I guess you’d need some form of deposit insurance (with the cost recovered through a fee the banks would pass on to depositors). Other lenders to the bank could be bailed in.

      • Deposit insurance?

        Er … I think not. That’s just another mechanism for the banksters to game (and leverage); a smokescreen, that serves the purpose of doing exactly what I complained about above … convincing the public that their savings are safe, when even a superficial inspection demonstrates they are not.

  2. Am I the only one here that thinks we should allow banks to fail?

    Essentially if a bank becomes insolvent then all creditors get wiped out or “bailed in”.

    Too Big To Fail has to stop now or the banks will become so big that not even the government can bail them out.

    • If they are to fail, why don’t we first separate the commercial bank activity from traditional intermediary bank activity? Then let commercial banks fail if they take too much risk and speculate on financial markets. The rest of the banking system will be stable with people’s savings and prudent allocation of banks loans for productive aims.

      • “The rest of the banking system will be stable with people’s savings and prudent allocation of banks loans for productive aims.”

        I assume that we’re not talking about Australian banks then.

    • Certainly not the only one! I don’t we should “let them fail” I think we should put straight into receivership as soon as they’re books call for it like any other corporation

    • “Am I the only one here that thinks we should allow banks to fail?”

      Absolutely not! I think you’d find a rather large amount of support here for that idea. It’s got my vote.

    • No, in fact I think it should be legislated that the government can’t bail out, in the sense of ensuring the survival of the bank as it is.

      What we have to avoid is conflating the task of banking, vs the private entity conducting banking.

      We need to eliminate poor performers, and owners equity needs to bear the brunt of it.

      People think I jest, but I do believe we need to have the death penalty for CEO’s of banks that fail.

      Death to the participant is the only observed disincentive to poor performance when game theory is considered.

      Liegislation should be a guarantee to Australian depositors only, capped at say 5-10 times wages, everything else forfeits, the goverment assumes control of the bank, recapitalises it then sells it back on the market.

      CEO dead
      Management purged
      Shareholders lose everything
      Foreign bond holders lose everything

      Banking service uninterupted.

      No broad(er) market disruption.

  3. Is this any more complicated than just putting a Bill through that says something along the lines that all registered ADI’s must make available an account to each customer that provides the customer with 100% secured funds? And then ensuring that in a liquidation scenario customers do have 100% secure funds..

    Then let the market sort itself out and banks can fail whenever they need to.