Get ready for Too-Big-to-Fail envy

at 09:00 AM ET, 12/22/2011

Regulators across the globe have been trying to rein in banks that have gotten so big, risky, and complex that they could bring down the whole financial system. In the United States and Europe, big banks that regulators consider systemically risky are now increasingly subject to regulation. But it turns out that there’s an upside to being labeled “too big to fail.”


(GETTY IMAGES)

In early November, the G-20 designated 29 financial institutions as “systemically important financial institutions,” or G-Sifis, that would be required to hold higher levels of capital, which could affect some of these banks’ returns. But there’s a distinct upside to being subjected to additional regulatory scrutiny. “[I]n the eyes of credit-rating agencies and customers, banks with a G-Sifi label will be deemed stronger counterparties. In certain businesses, particularly foreign exchange, credit derivatives, cash management, transaction processing and even equity and fixed-income trading, this competitive edge could outweigh the cost of holding more capital,” explains Rob Cox and Peter Thal Larsen. Such advantages have even give rise to “G-Sifi” envy by banks that didn’t get the G-20 label.

There could be a similar scenario in the United States, depending on how vigorously the new banking regulations are enforced. Dodd-Frank imposes stricter capital levels for banks with more than $50 billion in assets and gives the government new authority to liquidate troubled, risky firms. But the new rules don’t directly limit the size of big, risky financial institutions. And some critics warn that the benefits will still outweigh the costs, as the market will implicitly consider them “too big to fail.”

“Debt holders of major financial institutions have an expectation that the government will shield them from losses and, as a result, they do not accurately price risk,” Joseph Warburton and Deniz Anginer wrote recently. “This expectation of public support constitutes a subsidy to large financial institutions, lowering their funding cost.”

 
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