We obtained perspectives on the potential impacts of  We conducted interviews with representatives from 10 investment firms  and six corporations to learn about (1) factors that influence their  decisions to invest in or do business with bank holding companies of  various sizes; (2) how they assess the risks of banks and the extent to  which they rely on credit rating agencies’ assessments of these risks; (3)  their views on the likelihood that the federal government would intervene  to prevent the failure of a large bank holding company and factors that  have influenced these views over time; and (4) how, if at all, expectations  of government support have impacted their decisions to invest in or do  business with banks of various sizes. To inform our econometric approach and understand  the breadth of results and methodological approaches, we reviewed  studies that estimated the funding cost difference between large and  small financial institutions that could be associated with the perception  that some institutions are too big to fail. We used these data to assemble a dataset with one observation for each  bond in each quarter from the first quarter of 2006 through the fourth  quarter of 2013. We developed a variety of econometric models that use alternative  measures of bond liquidity, bank holding company credit risk, and the size  or systemic importance of a bank holding company. We estimated the  parameters for each of our models separately for each year from 2006  through 2013 to allow the relationship between bank holding company  size and bond funding costs to vary over time. In addition, we assessed the impact  of credit risk on our comparisons by making comparisons at credit risk  levels higher and lower than the average for each year and also while  holding the level of credit risk constant over time at the average level for  2008—the year when the financial crisis peaked and credit risk for bank  holding companies was high. To summarize the overall relationship between  bond funding costs and size reflected in each specification, we calculated bond funding  costs for bank holding companies of different sizes and credit risk levels using our  estimates of the parameters for each specification for each year. also took steps to prevent the failures of large financial institutions. Orderly Liquidation Authority. Other Reforms. Two of the three largest credit rating agencies  cited FDIC’s resolution process as a key factor in their decisions to  reduce or eliminate “uplift”—an increase in the credit rating—they had  assigned to the credit ratings of eight of the largest bank holding  companies due to their assumptions of government support for these  firms. Enhanced regulatory standards. Remaining Market Expectations of Government Support Can Have Benefits for Large Firms

Remaining market assumptions about government support can give rise  to advantages for the largest bank holding companies in three broad  categories to the extent these assumptions affect decisions by investors,  counterparties, and customers of these firms. Funding Costs

Market beliefs about government support could benefit a firm by lowering  its funding costs. In the section addressing the second objective of this  report, we analyze the existence and size of potential funding cost  advantages for the largest bank holding companies using quantitative  approaches that control for factors outside of government support that  can influence funding cost differences. Higher capital and liquidity requirements for banks can increase their  funding and other costs. Evidence Suggests Large Banks Had a Funding Cost Advantage over Small Ones during the Financial Crisis That May Have Declined or Reversed Since

Our analysis and the results of studies we reviewed provide evidence that  the largest bank holding companies had lower funding costs than smaller  bank holding companies during the 2007-2009 financial crisis but that  differences may have declined or reversed in more recent years. Studies Generally Found the Largest Banks Had Lower Funding Costs during the Financial Crisis but Results Have Limitations

Studies we reviewed generally found that the largest financial institutions  had lower funding costs than smaller ones during the 2007-2009 financial  crisis but that the difference between the funding costs of the largest and  smaller financial institutions has since declined. In some cases these  findings could be interpreted as evidence of advantages driven by too- big-to-fail perceptions; however, these empirical analyses are imperfect  and contain a number of limitations that could reduce their validity or  applicability to U.S. bank holding companies. However, in  hypothetical scenarios where levels of credit risk in every year from 2010  to 2013 are assumed to be as high as they were during the financial  crisis, our analysis suggests that large bank holding companies might  have had lower funding costs than smaller bank holding companies. Although our analysis improves on certain aspects of prior studies,  important limitations remain and our results should be interpreted with  caution. These models estimate  the relationship between bank holding companies’ bond funding costs  and their size, while also controlling for other drivers of bond funding  costs, including credit risk and bond liquidity. Key features of our  econometric approach include the following:
U.S. bank holding companies. To better understand the relationship  between bank holding company funding costs and size in the context  of the current economic and regulatory environment, we analyzed the  period from 2006 through 2013, which includes the recent financial  crisis as well as years before the crisis and following the enactment of  the Dodd-Frank Act. Bond funding costs. We used bond yield spreads as our measure of  bank holding company funding costs because they are a direct  measure of what investors charge bank holding companies to borrow  money and because they are sensitive to credit risk and hence  expected government support. Extensive controls for bond liquidity, credit risk, and other key  factors. To account for the many factors that could influence funding  costs, we controlled for credit risk, bond liquidity, and other key factors  in our models. Multiple model specifications. In order to assess the sensitivity of  our results to using alternative measures of size, bond liquidity, and  credit risk discussed above, we estimated multiple different model  specifications. Link between size and credit risk. Altogether, we estimated 42 different models for each year from 2006  through 2013 and then used these models to compare bond yield  spreads—our measure of bond funding costs—for bank holding  companies of different sizes but with the same level of credit risk. Figure  1 shows our models’ comparisons of the difference between bond funding  costs for bank holding companies with $1 trillion in assets and average  credit risk and bond funding costs for similar bank holding companies with  $10 billion in assets, for each model and for each year. Each circle and  dash in figure 1 shows the comparison of bond funding costs for a  different model. Circles show model-estimated differences that were  statistically significant at the 10 percent level, while dashes represent  differences that were not statistically significant at that level.dashes below zero correspond to models suggesting that bank holding  companies with $1 trillion in assets have lower bond funding costs than  bank holding companies with $10 billion in assets, and vice versa. In addition, our estimates of differences in bond funding costs for bank  holding companies of different sizes may reflect factors other than  investors’ beliefs about the likelihood of government support. Furthermore, as we  have noted, many market participants we spoke with believe that recent  regulatory reforms have reduced but not eliminated the perception of “too  big to fail” and both they and Treasury officials indicated that additional  steps were required to address “too big to fail.” As discussed in the final  section of our report on page 56, changes over time in our estimates of  the relationship between bond funding costs and size may reflect  changes in one or more components of investors’ beliefs about  government support—such as their views on the likelihood that a bank  holding company will fail and the likelihood it will be rescued if it fails—but  we cannot precisely identify the influence of each of these components  with certainty. While we agree that  bank holding companies with $50 billion in assets may be more  similar to $1 trillion bank holding companies than bank holding  companies with $10 billion in assets, we used a smaller size for  small bank holding companies because bank holding companies  with $50 billion or more in assets may be viewed by investors as  “large” and systemically important, in part because $50 billion in  assets is the size threshold for Dodd-Frank Act requirements  related to enhanced regulatory standards. Methodology for Analysis of Funding Cost Differences between Large and Small Bank Holding Companies

To assess the extent to which the largest bank holding companies have  received funding cost advantages as a result of perceptions that the  government would not allow them to fail, we conducted an econometric  analysis of the relationship between a bank holding company’s size or  systemic importance and its funding costs. We used bond yield spreads—the difference between the rate  of return on a bond and the rate of return on a Treasury bond of  comparable maturity to measure a bank holding company’s cost of bond  funding.
Why GAO Did This Study

“Too big to fail” is a market notion that the federal government would intervene to prevent the failure of a large, complex financial institution to avoid destabilizing the financial sector and the economy. Expectations of government rescues can distort investor incentives to properly price the risks of firms they view as too big to fail, potentially giving rise to funding and other advantages for these firms.
GAO was asked to review the benefits that the largest bank holding companies (those with more than $500 billion in assets) have received from perceived government support. This is the second of two GAO reports on government support for bank holding companies. The first study focused on actual government support during the 2007-2009 financial crisis and recent statutory and regulatory changes related to government support for these firms. This report examines how financial reforms have altered market expectations of government rescues and the existence or size of funding advantages the largest bank holding companies may have received due to perceived government support.
GAO reviewed relevant statutes and rules and interviewed regulators, rating agencies, investment firms, and corporate customers of banks. GAO also reviewed relevant studies and interviewed authors of these studies. Finally, GAO conducted quantitative analyses to assess potential “too-big-to-fail” funding cost advantages.
In its comments, the Department of the Treasury generally agreed with GAO's analysis. GAO incorporated technical comments from the financial regulators, as appropriate.

What GAO Found

While views varied among market participants with whom GAO spoke, many believed that recent regulatory reforms have reduced but not eliminated the likelihood the federal government would prevent the failure of one of the largest bank holding companies. Recent reforms provide regulators with new authority to resolve a large failing bank holding company in an orderly process and require the largest bank holding companies to meet stricter capital and other standards, increasing costs and reducing risks for these firms. In response to reforms, two of three major rating agencies reduced or removed the assumed government support they incorporated into some large bank holding companies' overall credit ratings. Credit rating agencies and large investors cited the new Orderly Liquidation Authority as a key factor influencing their views. While several large investors viewed the resolution process as credible, others cited potential challenges, such as the risk that multiple failures of large firms could destabilize markets. Remaining market expectations of government support can benefit large bank holding companies if they affect investors' and customers' decisions.
GAO analyzed the relationship between a bank holding company's size and its funding costs, taking into account a broad set of other factors that can influence funding costs. To inform this analysis and to understand the breadth of methodological approaches and results, GAO reviewed selected studies that estimated funding cost differences between large and small financial institutions that could be associated with the perception that some institutions are too big to fail. Studies GAO reviewed generally found that the largest financial institutions had lower funding costs during the 2007-2009 financial crisis but that the difference between the funding costs of the largest and smaller institutions has since declined. However, these empirical analyses contain a number of limitations that could reduce their validity or applicability to U.S. bank holding companies. For example, some studies used credit ratings which provide only an indirect measure of funding costs.
GAO's analysis, which addresses some limitations of these studies, suggests that large bank holding companies had lower funding costs than smaller ones during the financial crisis but provides mixed evidence of such advantages in recent years. However, most models suggest that such advantages may have declined or reversed. GAO developed a series of statistical models that estimate the relationship between bank holding companies' bond funding costs and their size or systemic importance, controlling for other drivers of bond funding costs, such as bank holding company credit risk. Key features of GAO's approach include the following:
U.S. Bank Holding Companies: The models focused on U.S. bank holding companies to better understand the relationship between funding costs and size in the context of the U.S. economic and regulatory environment.
Bond Funding Costs: The models used bond yield spreads—the difference between the yield or rate of return on a bond and the yield on a Treasury bond of comparable maturity—to measure funding costs because they are a risk-sensitive measure of what investors charge bank holding companies to borrow.
Extensive Controls : The models controlled for credit risk, bond liquidity, and other variables to account for factors other than size that could affect funding costs.
Multiple Models : GAO used 42 models for each year from 2006 through 2013 to assess the impact of using alternative measures of credit risk, bond liquidity, and size and to allow the relationship between size and bond funding costs to vary over time with changes in the economic and regulatory environment.
Credit Risk Levels : GAO compared bond funding costs for bank holding companies of different sizes at the average level of credit risk for each year, at low and high levels of credit risk for each year, and at the average level of credit risk during the financial crisis.
The figure below shows the differences between model-estimated bond funding costs for bank holding companies with $1 trillion in assets and bank holding companies with $10 billion in assets, with average levels of credit risk in each year. Circles represent statistically significant model-estimated differences.
Estimates from 42 Models of Average Bond Funding Cost Differences between Bank Holding Companies with $1 Trillion and $10 Billion in Assets, 2006-2013
Notes: GAO estimated econometric models of the relationship between BHC size and funding costs using data for U.S. BHCs and their outstanding senior unsecured bonds for the first quarter of 2006 through the fourth quarter of 2013. The models used bond yield spreads to measure funding costs and controlled for credit risk factors such as capital adequacy, asset quality, earnings, maturity mismatch, and volatility, as well as bond liquidity and other characteristics of bonds and BHCs that can affect funding costs. GAO estimated 42 models for each year from 2006 through 2013 to assess the sensitivity of estimated funding cost differences to using alternative measures of capital adequacy, volatility, bond liquidity, and size or systemic importance. GAO used the models to compare bond funding costs for BHCs of different sizes but the same levels of credit risk, bond liquidity, and other characteristics. This figure compares bond funding costs for BHCs with $1 trillion and $10 billion in assets, for each model and for each year, with average levels of credit risk. Each circle and dash shows the comparison for a different model, where circles and dashes below zero suggest BHCs with $1 trillion in assets have lower bond funding costs than BHCs with $10 billion in assets, and vice versa.
All 42 models found that larger bank holding companies had lower bond funding costs than smaller ones in 2008 and 2009, while more than half of the models found that larger bank holding companies had higher bond funding costs than smaller ones in 2011 through 2013, given the average level of credit risk each year (see figure). However, the models' comparisons of bond funding costs for bank holding companies of different sizes varied depending on the level of credit risk. For example, in hypothetical scenarios where levels of credit risk in every year from 2010 to 2013 are assumed to be as high as they were during the financial crisis, GAO's analysis suggests that large bank holding companies might have had lower funding costs than smaller ones in recent years. However, reforms in the Dodd-Frank Wall Street Reform and Consumer Protection Act, such as enhanced standards for capital and liquidity, could enhance the stability of the financial system and make such a credit risk scenario less likely.
This analysis builds on certain aspects of prior studies, but important limitations remain and these results should be interpreted with caution. GAO's estimates of differences in funding costs reflect a combination of several factors, including investors' beliefs about the likelihood a bank holding company will fail and the likelihood it will be rescued by the government if it fails, and cannot precisely identify the influence of each factor. In addition, these estimates may reflect factors other than investors' beliefs about the likelihood of government support and may also reflect differences in the characteristics of bank holding companies that do and do not issue bonds. Finally, GAO's estimates, like all past estimates, are not indicative of future trends.