04/25/2013 10:02 pm ET Updated Apr 26, 2013

FSOC Warns On Too-Big-To-Fail Banks

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WASHINGTON -- The biggest U.S. banks may be encouraged to take excessive risks due to assumptions they’ll be rescued by the government, a potential emerging threat to financial stability, a panel of top regulators warned Thursday.

The note of caution, contained in the Financial Stability Oversight Council’s latest annual report detailing risks to the financial system, comes as the debate over the market phenomenon “too-big-to-fail” grips Washington and Wall Street, three years after the problem was supposed to have been solved. The Obama administration and large banks are on one side; some regulators and lawmakers are on the other.

The nine government agencies that form FSOC, including the Treasury Department, said in their joint report that perceptions in financial markets that the U.S. government inevitably will bail out faltering financial institutions diminishes discipline at the biggest banks by allowing them to borrow more cheaply than other financial institutions.

The acknowledgement and warning may boost claims by some lawmakers and regulators that the largest and most complex financial groups are too big to fail and should be broken up. It also may undercut arguments by officials and industry executives fighting those efforts.

The Treasury Department has been trying to rebut allegations that the biggest banks remain too big to fail in the wake of the 2010 law that overhauled financial regulation known as Dodd-Frank.

Last week, Mary Miller, the Treasury Department under secretary for domestic finance, said the “notion that the government will bail a company out if it is in danger of collapse because its failure would otherwise have too great a negative impact on the financial system or the broader economy ... is wrong.”

Top officials at the Federal Deposit Insurance Corp. and the Federal Reserve, including Fed chairman Ben Bernanke, have said recently that some banks continue to enjoy lower funding costs due to the assumption they’d be bailed out if nearing failure.

Claims of a subsidy -- that creditors lend at lower rates to the biggest banks because they know they’ll never have to suffer losses in the event of a failure -- have driven the legions of bankers that form the Independent Community Bankers of America, and lawmakers including Sens. Sherrod Brown (D-Ohio) and David Vitter (R-Louisiana) to support legislation that would effectively break up the biggest banks.

The subsidy is unfair, they reckon, and breaking up large financial institutions would stamp it out. The Senate recently passed a nonbinding measure by a 99-0 vote to end the subsidy that results from the implicit government backstop.

Brown and Vitter on Wednesday introduced a bill that would force the biggest banks to fund themselves with substantially more equity, rather than with borrowed money.

Analysts at Standard & Poor's, the credit rating agency, estimated Thursday that the six biggest banks in the U.S. -- JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley -- would have to raise nearly $1.2 trillion in additional capital to meet the proposed legislation’s requirements.

Bank lobbyists and representatives in Washington have criticized the bill. They’ve also contested claims of a subsidy.

Miller said April 18 that “the evidence is mixed whether market participants, specifically lenders to bank holding companies, nonetheless provide any funding advantage to the biggest financial companies based on some belief that the government would bail them out if necessary.”

She added that the reason big banks borrow borrow cheaper is “mixed and complicated, making it hard to attribute the existence or absence of a funding cost advantage to any single factor, including a market perception of a too-big-to-fail subsidy.”

In its report, FSOC attributed the funding advantage to credit rating agencies, which have concluded that the biggest banks are more creditworthy because the government effectively guarantees their liabilities. While the perception of government support has decreased, it has not disappeared, FSOC said.

“Vulnerabilities can arise when a financial institution’s funding model depends in part on the belief that the government will provide support, rather than solely on the intrinsic strength of the institution and its portfolio,” FSOC cautioned.

Miller attributed big banks’ funding advantage to a variety of factors, such as their relative creditworthiness, the amount of their borrowings, and the diversity of their business lines.

“The bottom line is simply that it is important to acknowledge the difficulty of making these assessments and to be cautious about drawing conclusions in either direction,” Miller said.

Bank representatives cheered her statements.