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Banks aren't too big to fail now -- unless they fail

The Government Accountability Office recently announced a study on whether there's a too-big-to-fail subsidy for big banks.

The answer is complicated, in part because the GAO ran 42 different regression models, and they all got different answers: "All 42 models found that larger bank holding companies had lower bond funding costs than smaller ones in 2008 and 2009, while 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.

"However, the models' comparisons of bond funding costs for bank holding companies of different sizes varied depending on the level of credit risk," according to the study. "For example, in hypothetical scenarios where levels of credit risk in every year from 2010 to 2013 are assumed to be as high as they were during the financial crisis, GAO's analysis suggests that large bank holding companies might have had lower funding costs than smaller ones in recent years.

"However, reforms in the Dodd-Frank Wall Street Reform and Consumer Protection Act, such as enhanced standards for capital and liquidity, could enhance the stability of the financial system and make such a credit risk scenario less likely."

I think you need a model for these models: One simple model is that the too-big-to-fail subsidy -- meaning the amount of money that big banks save on funding costs because their creditors assume that if anything goes wrong the government will bail them out -- is like a put option, putting some floor on the value of a bank's assets.

When the put option is at-the-money -- when things are bad and the bank looks like it might default without government support -- then it's worth a lot. When the put option is out of the money -- when things are good and the bank is fine on its own -- then it's worth less.

So now it's worth less than it was worth in 2008, or in a hypothetical 2013 with 2008's credit conditions.

In fact, it has negative value, which is weird in a put option, but not that weird in life. It's like insurance: You pay a premium every month, and it pays off when things go bad.

Some months the premium is worth more than the insurance, in expectation, and some months it's worth less. That's how insurance works: It looks like a bad deal in good times, but a good deal in bad times.

Now you might say: But banks don't pay for the too-big-to-fail subsidy! We need to charge them for it! But I'm not quite sure that's true.

One study argued that post-crisis banking reforms cost the six biggest U.S. banks about $35 billion a year, most of that from increased capital requirements.

Some of those requirements apply mostly to the biggest banks, and there are other bigness-focused requirements too -- stress tests, living wills, liquidity buffers -- that further push up the cost of being big.

These costs aren't explicitly paid to the government as insurance premium, but that's okay: The government imposes those costs in order to reduce the likelihood that the insurance will have to pay.

A simpler way of putting this is: Big banks actually have higher funding costs than little banks. If you try to isolate their bond funding costs, and then regress against various measures of credit quality, you'll get whatever you get depending on what you regress.

But if you just divide funding costs (interest expense and maybe cost of equity) by assets, the big banks have higher costs, because they rely more on expensive long-term funding than on the cheap financing (mainly deposits) that little banks use. That more expensive funding is the premium they pay for their improved odds of getting a bailout.

The Bloomberg View editors remain troubled by too-big-to-fail, and fair enough. But it's worth spending a few minutes pretending to take this GAO report literally, because if you do, its message is something like: Bigness is not the problem.

In 2014, in good credit conditions, big banks can ... fail? Probably? Maybe?

That's what Dodd-Frank's "living wills" and "orderly liquidation authority" mean: There are mechanisms for regulators to come in, grab a bank, zero its equity, write down its holding-company creditors, and keep its systemic businesses intact and functioning.

And this study says: Those mechanisms should, in expectation, work. So if, for instance, Goldman Sachs announces tomorrow that Lloyd Blankfein has stolen $100 billion and lit it on fire, leaving Goldman with a negative capital position and a diminished reputation, then regulators could step in, zero Goldman's shareholders, ding its bondholders, but prevent contagion to the broader financial system.

Derivatives contracts would still be honored, repo creditors wouldn't flee, bank depositors would be fine, etc. You may or may not believe that, but the point of the GAO study is that the market does.

And every so often huge banks fail idiosyncratically, so I guess that's nice. But the bigger worry, poorly captured by the name "too big to fail," is that a big bank will be in trouble at the same time, and for the same reasons, as every other big bank.

I recently mentioned a Minneapolis Fed economic policy paper called "Too Correlated to Fail," which argues that "the anticipation of bailouts creates incentives for banks to herd in the sense of making similar investments. Policymakers do not intervene when big banks are threatened simply because those banks are too big. Rather, they intervene because the potential systemic costs resulting from bank failure are considered too big."

And those systemic costs are much higher in bad times. If you start Lehman Nephews tomorrow, grow it to $600 billion of assets next week by buying Argentinean bonds and knockoff messaging-app stocks, and then blow it up and file for bankruptcy, the financial system will probably be fine.

The Lehman Brothers bankruptcy was a problem not just as a cause but as a symptom: everyone had worrying exposure to mortgages, everyone knew that everyone had worrying exposures to mortgages, then everyone saw that those mortgage exposures blew up Lehman, everyone realized that everyone had exposures to Lehman in addition to their already worrying exposures to mortgages, and everyone panicked.

In circumstances like those, pulling out a "living will" and haircutting Lehman's bonds would not have done much to stem the panic. And the GAO study tells us that too: If credit conditions were now what they were in 2008, the government probably wouldn't let big banks fail.

I guess you can regret that, but ultimately all it means is that the financial system is financially systemic.

Panics are bad, and there's a role for central banks to stop them, and that role tends to be profitable in the long term, but look like a bailout in the short term.

As Tim Geithner says, "the existence of firehouses doesn't cause fires." You can't make financial crises go away by just promising really hard never to bail anyone out.

But that doesn't mean that nothing has been accomplished. As the GAO says, the new, boring and well-capitalized banking regime "could enhance the stability of the financial system and make such a credit risk scenario less likely."

That would be nice. And it's a more important, and more achievable, goal than convincing the market that no one will ever be bailed out again.

Levine is a Bloomberg View columnist writing about Wall Street and the financial world.

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