A landmark study by Federal Reserve economists found that large U.S. banks enjoy a "too-big-to-fail" advantage in financial markets, joining a heated debate that could influence regulators that are implementing tough new rules for Wall Street.
The series of research papers, published on Tuesday by the U.S. central bank's influential New York branch, suggests the biggest banks benefited even after the financial crisis from lower funding and operating costs compared with smaller ones. The researchers used data through 2009, which did not reflect post-crisis reforms.
Fed economists also found that the biggest banks can take bigger risks than their smaller peers.
While the study did not pinpoint the reason big banks can borrow more cheaply, Wall Street critics say it is because investors believe the U.S. government would again rescue them in a panic.
The new research shows "it is improper to ask the taxpayer to underwrite the non-commercial banking operations of a complex bank holding company," Dallas FedPresident Richard Fisher, a long-time critic of big banks, said in an interview.
Fed economists estimated the funding advantage for the five largest banks over smaller peers to be about 0.31 percent, which they said was statistically significant. The Fed said the papers represented the conclusions of their individual authors, not the central bank itself.
The study did not look at whether the advantage persists as regulators implement the 2010 Dodd-Frank Wall Street law. Banks and their critics have been at loggerheads for years over whether the law did enough to prevent regulators from bailing out banks in a future crisis.
Rob Nichols, chief executive of the Financial Services Forum, which represents big banks, said the Fed researchers noted that the advantage could exist because big banks offer more products and can better diversify risk.
"They actually do say that the apparent cost of funding advantage could be attributable to the diversity and stability of large financial institutions," Nichols said.
The Clearing House, an industry group for the biggest banks, published a study last week that was conducted by consulting firm Oliver Wyman. It found the difference in funding costs between large and small firms was negligible.
But skeptics in Congress still warn that the nation's biggest banks like Bank of America Corp <BAC.N> and JPMorgan Chase & Co <JPM.N> are still viewed as too integral to the U.S. economy to fail.
U.S. Senator Sherrod Brown, an Ohio Democrat, called The Clearing House study an attempt by banks to "protect the status-quo that requires hardworking taxpayers to pay for their risky activities."
SOLUTIONS
The New York branch conducts the Fed's trading in financial markets and is its frontline in supervising Wall Street.
Its staff warned against taking its findings to mean regulators should break up the biggest banks. That could disrupt economies of scale that keep the cost of banking services low for most Americans, they said.
They noted that limiting bank holding companies' assets to no more than 4 percent of U.S. gross domestic product, as some have suggested, would increase industry-wide non-interest expenses by $2 billion to $4 billion each quarter.
Fed economists said regulators should focus on banks' liabilities rather than trying to revamp their structure.
They suggested requiring banks to issue minimum amounts of long-term debt, also referred to as 'bail-in' debt. Under new U.S. rules, if a bank failed, its shareholders would be wiped out and holders of long-term debt of the holding company, or parent, would become the new shareholders.
The Federal Deposit Insurance Corp has said a bail-in stipulation would fit well with its plans for resolving failed banks. The Fed is considering writing the requirement.
"Parent-level bail-in is quick and simple, compared to the alternatives," Joseph Sommer, an assistant vice president at the New York Fed, wrote in a paper titled "Why Bail-In? And How!"
"At worst, bail-in creates orderly liquidation."
Regulators could link the new requirement to banks' use of risky liabilities such as uninsured deposits, repurchase agreements, or repos, or commercial paper, four New York Fed researchers argued in a separate paper.
Relying on those liabilities, which are subject to runs in crises, makes bank failures costly and threatens the stability of financial markets, wrote James McAndrews, head of research at the New York Fed, and three others.
If regulators forced banks to offset those liabilities with long-term debt, the firms would have less incentive to use risky funding sources, they said.
(Reporting by Jonathan Spicer and Emily Stephenson; Editing by Karey Van Hall, Paul Simao and Chizu Nomiyama)
