Quantifying Structural Subsidy Values for Systemically Important Financial Institutions. By Kenichi Ueda and Beatrice Weder
IMF Working Paper No. 12/128
Summary: Claimants to SIFIs receive transfers when governments are forced into bailouts. Ex ante, the bailout expectation lowers daily funding costs. This funding cost differential reflects both the structural level of the government support and the time-varying market valuation for such a support. With large worldwide sample of banks, we estimate the structural subsidy values by exploiting expectations of state support embedded in credit ratings and by using long-run average value of rating bonus. It was already sizable, 60 basis points, as of the end-2007, before the crisis. It increased to 80 basis points by the end-2009.
One of the most troubling legacies of the financial crisis is the problem of “too-systemically important-to-fail” financial institutions. Public policy had long recognized the dangers that systemically relevant institutions pose for the financial system and for public sector balance sheets, but in practice, this problem was not deemed to be extremely pressing. It was mainly dealt with by creating some uncertainty (constructive ambiguity) about the willingness of government intervention in a crisis.
The recent crisis since 2008 provided a real-life test of the willingness to intervene. After governments have proven their willingness to extended large-scale support, constructive ambiguity has given way to near certainty that sufficiently large or complex institutions will not be allowed to fail. Thus, countries have emerged from the financial crisis with an even larger problem: Many banks are larger than before and so are implicit government guarantees. In addition, it also becomes clear that these guarantees are not limited to large institutions. In Europe, smaller institutions with a high degree of interconnectedness, complexity, or political importance were also considered too important to fail.
The international community is addressing the problem of SIFIs with a two-pronged approach. On the one hand, the probability of SIFIs failure is to be reduced through higher capital buffers and tighter supervision. On the other hand, SIFIs are to be made more “resolvable” by subjecting them to special resolutions regimes (e.g., living wills and CoCos). A number of countries have already adopted special regimes at the national level or are in the process of doing so. However, it remains highly doubtful whether these regimes would be operable across borders. This regulatory coordination failure implies that creditors of SIFIs continue to enjoy implicit guarantees.
Subsidies arising from size and complexity create incentives for banks to become even larger and more complex. Hence, eliminating the value of the implicit structural subsidy to SIFIs should contribute to reducing both the probability and magnitude of (future) financial crises. Market participants tend to dismiss these concerns by stating that these effects may be there in theory but are very small in practice. Therefore, it requires an empirical study to quantify the value of state subsidies to SIFIs. This is the aim of this paper.
How can we estimate the value of structural state guarantees? As institutions with state backing are safer, investors ask for a lower risk premium, taking into account the expected future transfers from the government. Therefore, before crisis, the expected value of state guarantees is the difference in funding costs between a privileged bank and a non-privileged bank. A caveat of this reasoning is that this distortion might affect the competitive behaviors and the market shares of both the subsidized and the non-subsidized financial institutions. Therefore, the difference in observed funding costs may include indirect effects in addition to the direct subsidy for SIFIs.
We estimate the value of the structural subsidy using expectations of government support embedded in credit ratings. Overall ratings (and funding costs) of financial institutions have two constituent parts: their own financial strength and the expected amount of external support. External support can be provided by a parent company or by the government. Some rating agencies (e.g., Fitch) provide regular quantitative estimates of the probability that a particular financial institution would receive external support in case of crisis. We isolate the government support component and provide estimates of the value of this subsidy as of end-2007 and end-2009.
We find that the structural subsidy value is already sizable as of end-2007 and increased substantially by the end-2009, after key governments confirmed bailout expectations. On average, banks in major countries enjoyed credit rating bonuses of 1.8-3.4 at the end-2007 and 2.5-4.2 at the end-2009. This can be translated into a funding cost advantage roughly 60bp and 80bp, respectively.
The use of ratings might be considered problematic because rating agencies have been known to make mistakes in their judgments. For instance, they have been under heavy criticism for overrating structured products in the wake of the financial crisis. However, whether rating agencies assess default risks correctly is not important for the question at hand. All that matters is that markets use ratings in pricing debt instruments and those ratings influence funding costs. This has been the case.6 Therefore, we can use the difference in overall credit ratings of banks as a proxy for the difference in their structural funding costs. Our empirical approach is to extract the value of structural subsidy from support ratings, while taking into account bank-specific factors that determine banks’ own financial strength as well as country-specific factors that determine governments’ fiscal ability to offer support.
A related study by Baker and McArthur (2009) obtains a somewhat lower value of the subsidy, ranging from 9 bp to 49 bp. However, the difference in results can be explained by different empirical strategies: Baker and McArthur use the change in the difference in funding costs between small and large US banks before and after TARP. With this technique, they identify the change in the value of the SIFIs subsidy, which is assumed to be created by the government bailout intervention. However, they cannot account for a possible level of bailout expectations that may have been embedded in prices long before the financial crisis. This ignorance is a drawback of all studies that use bailout events to quantify the value of subsidy: They can be quite precise in estimating the change in the subsidy due to a particular intervention but they will underestimate the total level of the subsidy if the support is positive even in tranquil times. In other words, they cannot establish the value of funding cost advantages accruing from expected state support even before the crisis.
This characteristic is the distinct advantage of the rating approach. It allows us to estimate not only the change of the subsidy during the crisis but also the total value of the subsidy before the crisis. As far as we are aware, there are only a few previous papers which use ratings. Soussa (2000), Rime (2005), and Morgan and Stiroh (2005) used similar approaches to back out the value of the subsidy. However, our study is more comprehensive by including a larger set of banks and countries and also by covering the 2008 financial crisis.
Assuming that the equity values are not so much affected by bailouts but the debt values are, the time-varying estimates of the government guarantees can be calculated using a standard option pricing theory.9 However, the funding cost advantage in crisis reflects two components: first, the structural government support and, second, a larger risk premium due to market turmoil. If we calculate the value of one rating bonus only in crisis times, the value of bonus would be larger because of the latter effect. However, when designing a corrective levy, the value of the government support should not be affected by these short-run market movements. For this reason, the long-run average value of one rating bonus—used here to calculate the total value of the structural government support—should be more suitable as a basis for a collective levy than real-time estimates for the market value of the government guarantees.
Interpretation and conclusion
Section III has provided estimates of the value of the subsidy to SIFIs in terms of the overall ratings. Using the range of our estimates, we can summarize that a one-unit increase in government support for banks in advanced economies has an impact equivalent to 0.55 to 0.9 notches on the overall long-term credit rating at the end-2007. And, this effect increased to 0.8 to 1.23 notches by the end-2009 (Summary Table 8). At the end-2009, the effect of the government support is almost identical between the group of advanced countries and developing countries. Before the crisis, governments in advanced economies played a smaller role in boosting banks’ long-term ratings. These results are robust to a number of sample selection tests, such as testing for differential effects across developing and advanced countries, for both listed and non-listed banks, and also correcting for bank parental support and alternative estimations of an individual bank’s strength.
In interpreting these results, it is important to check if the averages mask large differences across countries. In fact, the overall rating bonuses in a section of large countries seem remarkably similar (Summary Table 9). For instance, mean support of Japanese banks was unchanged at 3.9 in 2007 and 2009. This implies, based on regressions without distinguishing advanced and developing countries, that overall ratings of systemically relevant banks profited by 2.9-3.5 notches from expected government support in 2007, with the value of this support increasing to 3.4-4.2 notches in 2009. For the top 45 U.S. banks, the mean support rating increased from 3.2 in 2007 to 4.1 in 2009. This translates into a 2.4-2.9 overall rating bonus for supported banks in 2007 and a much higher, 3.6-4.5, notch impact in 2009. In Germany, government support started high at 4.4 in 2007 and slightly increased to 4.6 in 2009. This suggests a 3.3-4.0 overall rating advantage of supported banks in 2007 and a 4.1-5.1 notch rating bonus in 2009.
For selected countries that have large banking centers and/or have been affected by the financial crisis, average government support ratings are about 3.6 in 2007 and 3.8 in 2009 on average (see Table 2, based on U.S. top 45 banks). Thus the overall rating bonuses for supported banks in this sample of countries are 2.7-3.2 in 2007 and 3.4-4.2 in 2009.
Our three-notch impact, on average, for advanced countries in 2007 is comparable to the results found by Soussa (2000) and Rimes (2005), although their studies are less rigorous and based on a smaller sample. In addition, Soussa (2000) reports structural annualized interest rate differentials among different credit ratings based on the average cumulative default rates (percent) for 1920-1999, calculated by Moody’s.17 According to his conversion table, when issuing a five-year bond, a three-notch rating increase translates into a funding advantage of 5 bp to 128 bp, depending on the riskiness of the institution.18 At the mid-point, it is 66.5 bp for a three-notch improvement, or 22bp for one-notch improvement. Using this and the overall rating bonuses described in the previous paragraph, we can evaluate the overall funding cost advantage of SIFIs as around 60bp in 2007 and 80bp in 2009.
This is helpful information, for example, if one would like to design a corrective levy on banks, which extracts the value of the subsidy. The funding cost advantage can be decomposed into the level of the government support and the time-varying risk premium. If a corrective levy were to be designed, it should not be affected by short-run market movements but should reflect only the long-run average value of rating bonuses, used here to calculate the total value of the structural government support. As discussed above, we find that the level of the structural government support has increased in most countries in 2009 compared to 2007. Still, we note that our estimate for the value of government support is lower than the real-time market value during crisis.
Our estimate may be also an overestimate of the required tax rate that would neutralize the (implicit) SIFI subsidy, since the competitive advantage of a guaranteed firm versus a nonguaranteed firm can be magnified (the former gains market share and the latter loses market share). One possibility is that the advantages and disadvantages are equally distributed between the two firms. Then, the levy rate that would eliminate the competitive distortion is smaller than the estimated difference in the funding costs. In this simple example, it would be half of the values given above. Nevertheless, the corrective tax required to correct the distortion of government support would remain sizable.