Large Bank Strength and Resilience — A Reaction to the Financial Stability Board Evaluation of TBTF

27 Apr 2021
Read Time 4 mins

Introduction

In the years following the financial crisis and subsequent reforms, much has been written on the work of regulators and banks to improve the resiliency of large financial institutions.  Banks have performed exceptionally well during the pandemic, which has served as the first real test of those improvements.  Coinciding with that experience, the Financial Stability Board (FSB) released its final report on March 31 evaluating the effects of too-big-too-fail reforms.  The FSB wrote that “[t]he evaluation suggests that reforms have reduced systemic risks, enhanced the credibility of resolution and market discipline, and ultimately produced net benefits for society.”  It is important to note several key findings in the FSB report that are particularly relevant for U.S. Global Systemically Important Banks (GSIBs), all of which are Financial Services Forum members.  Also important is one finding from the study that is drawn broadly and therefore does not reflect the impact of reforms on the U.S. GSIBs.

The FSB Found Clear Improvements to Resiliency, Market Discipline and Resolvability

The FSB report rightly acknowledges the important and successful role played by total loss absorbing capacity requirements (TLAC) in improving the resiliency of GSIBs and improving the credibility of the resolution process.  As we have discussed before, he Federal Reserve requires all Forum members – and only Forum members –  to issue significant amounts of long-term debt to external third parties, that can be used to absorb losses and re-capitalize their institutions in the event of outsized financial losses.  In this context, private funding is intended to eliminate the need for public funding – a key post-crisis objective.  The FSB report shows the significant strides made in the U.S. relative to other jurisdictions.  Specifically, the report shows that the amount of TLAC issued by Forum members, relative to their overall size, outpaces that of other jurisdictions.  As we stated in our earlier comment letter on the draft FSB report, we believe that it is crucial to recognize important differences in the effectiveness of these and other reforms in the U.S. versus other jurisdictions.  The figure below from the FSB report depicts those differences

The chart shows the average ratio of TLAC to the leverage exposure of GSIBs across major jurisdictions.  As can be seen in the chart, in the U.S., Forum members maintain roughly a 13 percent ratio of TLAC to leverage exposure, which is significantly higher than any other jurisdiction.  Accordingly, the FSB report notes that Forum members are held to rigorous TLAC standards that surpass those in other jurisdictions.

The FSB also points out that market discipline among bank investors has improved markedly.  Specifically, the report cites the fact that credit rating agencies have removed their assumption of government support for GSIBs in a number of jurisdictions.  Importantly, the U.S. is one such jurisdiction where credit rating agencies have removed the “ratings uplift,” which is the increase in value of a GSIB’s debt associated with an assumption of government support in the event of financial stress. 

The FSB also found that “[r]isks arising from the shift of credit intermediation to non-bank financial intermediaries should continue to be closely monitored.”  The past decade has seen a marked increase in the size of the non-bank financial sector relative to the regulated banking sector and the FSB report discusses the need to closely monitor the risk arising from this trend.  Specifically, the report points to evidence from the pandemic that suggests “[t]he acute phase of the financial impacts of the COVID-19 pandemic in March 2020 suggests that some parts of the non-bank financial intermediation sector acted as propagators of the liquidity stress.”  As a result, the FSB is continuing to study and assess the impact of the growth of the non-bank financial sector on financial stability.  This work is important and we look forward to reviewing its findings.

Funding Costs for U.S. GSIBs

One finding that does not take account of the U.S. experience is the funding cost advantages attributed to GSIBs.  The report claims that funding advantages for GSIBs, globally, are no different than they were in 2007.  While that may be true in the aggregate for the 30 GSIBs, it is not consistent with the facts and research in the case of U.S. GSIBs. 

Recent research by economists at Stanford University and Australian National University, convincingly shows that funding costs for U.S. GSIBs have risen significantly since 2007 and have remained elevated since that time.  The figure below, taken directly from the research, shows:  1) the funding cost of U.S. GSIBs in the form of credit default swap rates from 2001-2007, and 2) the funding cost of U.S. GSIBs since 2007 (blue line) relative to the funding cost they would have faced had there been no change in funding costs for U.S. GSIBs (red line).  The data and analysis in the figure clearly show that funding costs for Forum members have risen substantially since 2007 and have remained elevated over the entire period.

Conclusion

Without question, the combination of reforms by banks and regulators has significantly improved the resiliency and resolvability of Forum members.  And the experience in the U.S. has generally been superior to that of other jurisdictions.  The effectiveness of these reforms is also reflected by improved market discipline and increased funding costs for Forum members.  The FSB report should give policymakers and the public additional confidence about the strength of the U.S. banking system, which has been strong and supported the economy over the course of the pandemic.   

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