The phrase ‘too big to fail’ can be interpreted in two ways – either to suggest that really big institutions are inherently stable thanks to their size and complexity (as they once said of the Titanic) or that the failure of such entities would leave such a big hole in the economy that governments cannot allow them to fail.

Unsurprisingly, the big noises of global finance prefer the former interpretation. What’s more they’ve been remarkably successful in persuading politicians of their version of events. That’s why, despite everything that’s happened over the last few years, governments – and especially the US government – have allowed the major banks to continue in their old ways.

On his Baseline Scenario blog, Simon Johnson draws upon memoirs of Jeff Connaughton – a veteran of various regulatory battles between Washington and Wall Street – to expose the slipperiness of the bankers’ arguments.

Consider, for instance, the issue of the hidden subsidies provided by the banking sector in the form of implicit guarantees that the state will always step in to save too-big-to-fail financial institutions. Apologists for the banks say that no such subsidies exist and the proof is that major financial firms with the same bond rating actually pay a higher rate of interest on their borrowings than comparable non-financial firms.

Sounds pretty conclusive, doesn’t it? And, no doubt, it is a fact regularly deployed by Wall Street’s army of lobbyists. And, yet, it is a misleading comparison:

  • “…the interest rate at which a company borrows depends not just on the risk of default, but also on the “recovery value” in the case of default (i.e., how much do creditors end up with after the company has been wound down).  If you think you will recover less when I default, you should charge me a higher risk premium – and thus a higher interest rate.”

So, because a non-financial company that’s run out of money tends to have a lot more in the way of recoverable assets than a financial company that’s run out of money, comparing the two in terms of risk to lenders doesn’t make much sense:

  • “The right comparison is the funding cost of financial firms with and without implicit government support.  The funding advantage for those perceived as Too Big To Fail is estimated to be between 25 and 75 basis points; most people close to the issue think it is at least 50 basis points.  The idea that megabanks do not get huge, implicit subsides is simply priceless – again, read Mr. Connaughton’s account to see the lengths to which the banks will go to ensure these subsidies are kept in place.”

A basis point is a hundredth of a percentage point. Fifty basis points is therefore half-a-percent, which given the massive borrowings of the major banks, makes a big difference to profit margins.

One more thing: If the size and complexity of the big banks really is a stabilising force – one worthy of a discounted interest rate – then why, in the event of each new banking scandal, do senior executives claim that they had no idea what was going on?

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