Bailout May Be Helping to Generate Up to Half of Bank’s Profits

We will never know how many, if any, of the major banks would have failed without the TARP bailout package passed a year ago. Several banks were strong-armed into taking the money. We can be reasonably sure that Citigroup and Bank of America wouldn’t be the institutions they are today without some government hand-holding—actually, it is more like continuous CPR while giving blood and donating a kidney.

However, while we can’t know the counterfactual, we can assess how the liquidity infusions have decreased credit risk, lowering the cost of capital, and compare these savings to profits. And the stunning numbers show that up to nearly half of all profits from the top 18 banks are the result of Uncle Sam subsidizing the cost of credit.

Every day financial firms borrow money to conduct business. Just like with individuals and families, there is a cost to the credit in the form of an interest payment or fee. However, with a virtual government guarantee of security, the big financial institutions have been able to borrow at artificially reduced rates. Lenders to financial institutions know Uncle Sam has the back of the big boys on Wall Street. They’re sure to get their money back, based on current White House and Fed policy.

The problem is that this gives large financial institutions a competitive advantage over smaller business. Those smaller firms have to pay more for their credit. They don’t have the government guarantee. They are more risky. And while it is true that smaller firms will always have to pay more money to borrow than the larger firms, the government guarantee has widened the gap between the cost of credit for the smalls and bigs.

This has been a generally accepted phenomena over the past year, but now we have some real numbers to back up the theory. The left-leaning Center for Economic and Policy Research (CEPR) released an interesting study last week that looked at the implicit benefits that banks have received from TARP and associated Federal Reserve programs. The report finds that banks have received up to $34.1 billion in benefits—beyond the $700 billion of TARP infusions—from cheap access to credit due to their too big to fail (TBTF) status.

Here is the gist of the study:

The spread between the average cost of funds for smaller banks and the cost of funds for institutions with assets in excess of $100 billion averaged 0.29 percentage points in the period from the first quarter of 2000 through the fourth quarter of 2007, the last quarter before the collapse of Bear Stearns. In the period from the fourth quarter of 2008 through the second quarter of 2009, after the government bailouts had largely established TBTF as official policy, the gap had widened to an average of 0.78 percentage points. [...] The increase in the gap of 0.49 percentage points implies a government subsidy of $34.1 billion a year to the 18 bank holding companies with more than $100 billion in assets in the first quarter of 2009.

Note that the “subsidy” mentioned here is not direct cash taken from taxpayer coffers, but rather it is a benefit that is gained by the promised use of taxpayer monies to insurance against losses/failure. This is the government using policy to redirect resources in the marketplace. Essentially this is saying that big banks were saved over $34.1 billion in costs.

To put that number in context, the total profits of the 18 largest banks during the second measured period from the end of 2008 to 2009 has been $68.56 billion, meaning the “subsidy” from cheaper access to credit accounts for nearly half of big bank profits. And, again, this not even counting the direct benefit that the capital infusions from TARP have provided.

The report also notes that $34.1 billion is the high end estimate and that there are other factors which could be considered as the cause for the increased spread in cost of credit. But if the high end estimate is correct, then government “subsidy” accounted for 166% of Capital One’s profits last year, and it prevented Morgan Stanley’s losses from being 50% larger. Those are very significant numbers when you consider what other uses the assets and resources these failing companies are consuming could be put towards.

If President Obama’s Wall St. regulation reform plan becomes law it will make TBTF explicit, perpetuating these associated problems with artificially reduced credit risk (which I wrote about in my recent financial services regulation study published by the Reason Foundation). As The New York Times puts it:

Too-big-to-fail is already an extremely costly policy; the longer it is allowed to persist, the heavier this taxpayer burden will become.

See here for the full CERP report and data.

For more on this, check out Reason’s blog Out of Control: New Study Suggests Nearly Half of Bank Profits Could Be From Too Big To Fail Guarantees