From the U.S. Government Accountability Office, www.gao.gov Transcript for: Expectations of Government Support for Large Bank Holding Companies Description: Audio interview by GAO staff with Lawrance Evans Jr., Director, Financial Markets and Community Investment Related GAO Work: GAO-14-621: Large Bank Holding Companies: Expectations of Government Support Released: July 2014 [ Background Music ] [ Narrator: ] Welcome to GAO's Watchdog Report, your source for news and information from the U.S. Government Accountability Office. It's July 2014. The perception among investors and credit agencies that a bank is “too big to fail” may affect how that bank's holding company competes in financial markets. A team led by Lawrance Evans, Jr., a director in GAO's Financial Markets and Community Investment team, recently looked at how expectations of government support affect large bank holding companies. GAO's Sarah Kaczmarek sat down with Lawrance to talk about what they found. [ Sarah Kaczmarek: ] Since the financial crisis, how have new regulations change the likelihood of the government stepping in to support banks? [ Lawrance Evans, Jr.: ] So there have been key provisions of the Dodd-Frank Act and other regulations that aim to reduce the likelihood of government support, and you can group them in 3 or 4 categories. The first category would be heightened prudential regulations, so these would include your enhanced capital standards, liquidity requirements, leverage limits, mandatory stress testing, activity restrictions, and new authorities that give regulators the ability to step in if they think a firm is posing unacceptable risk to the economy. And then there are new tools to resolve large complex, financial institutions, either through the bankruptcy process or outside of the bankruptcy process in an orderly fashion, and then lastly, there are restrictions on the ability of regulators to provide assistance. Any program now has to be broad-based and more importantly, no insolvent institutions can participate. Now, of course, there's some ongoing debate as to how effective these new reforms are. [ Sarah Kaczmarek: ] Now do investors still think that large banks are “too big to fail?” [ Lawrance Evans, Jr.: ] That's a good question. We interviewed representatives from 10 investment firms to obtain their perspectives on just that question. Now several said they thought the regulatory reforms had significantly reduced or eliminated expectations of government rescues. Others said they continue to expect the government to step in, in certain scenarios and one such scenario would be multiple large banks failing at the same time so that we have financial stability concerns. Now even though some investors indicated that they believe a bailout is possible in the future, they thought that there was some uncertainty around that probability so it didn't get factored into their investment decisions. Now, investors told us what they're thinking, but the data gives us an opportunity to analyze how they might be behaving. So we conducted our own original empirical work to see if large banks could fund themselves cheaper than smaller institutions, controlling for some of the various reasons why you might see those differences in the first place. Now because we were agnostic about the right model, we ran 42 different econometric models. All of the models suggested a funding cost advantage for large banks in 2008 and 2009; however, for the later years, particularly 2013, the models were not unanimous. Most models found that large banks did not have a funding cost advantage, but there was some notable exceptions and that creates some uncertainty and a call for caution and nuance. [ Sarah Kaczmarek: ] Could you give me an example of what a funding cost advantage is? [ Lawrance Evans, Jr.: ] For our purpose a funding cost advantage refers to a lower cost of borrowing money for one bank relative to another or for one group of banks relative to another group of banks, and so in bond markets you essentially are borrowing money so that means lower interest rates are required to pay to investors. [ Sarah Kaczmarek: ] It sounds like large banks aren't benefitting as much now from these expectations. Does this mean that the issue of being “too big to fail” has been solved? [ Lawrance Evans, Jr.: ] Certainly if you find our results credible, there's something to be optimistic about, but there are a few reasons why we wouldn't use the words “too big to fail” and “solved” in the same sentence. First, you know, even though we didn't find evidence of funding cost advantages in 2013, in general, some of our models did suggest those advantages existed. Secondly, we don't know how much of the improvement is due to the fact that institutions are now safer, they hold more capital, they've cleaned up their balance sheets, and how much of it is due to the change in expectation that the government would step in. And to further highlight that, we looked at a hypothetical scenario where we allowed credit risk conditions that approximate what happened during the financial crisis to re-emerge in our 2013 model, and when we did that we found some evidence, it was limited evidence, but we found some evidence that funding cost advantages would re-emerge. Now it's true that that's a hypothetical scenario and Dodd-Frank should make those type of credit risk scenarios less likely, but what I think it does highlight is that it would take another financial crisis to really test the financial regulatory reforms and know whether “too big to fail” has indeed been solved. [ Sarah Kaczmarek: ] Finally, what do you see at the bottom line of this report? [ Lawrance Evans, Jr.: ] On balance we think our analysis suggests that progress has been made on “too big to fail,” but it's far too early to declare victory. The largest banks have gotten larger since the onset of the financial crisis, and regulators need to finish the work that they've started to ensure that institutions don't again pose the type of risk that put taxpayers’ money on the line. I'd also want to be sure that readers understand the issues associated with our empirical work. Econometrics not an exact science, it’s full of methodological choices, limitations, areas where reasonable people will disagree, but we’ve put forth our best effort to try to analyze the data and navigate these challenges, but our work is not perfect. So readers need to interpret our results with a appropriate degree of caution and really think about them before leaping from our findings to public policy. 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