When enough is not enough: bank capital and the Too-Big-To-Fail subsidy
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When enough is not enough: bank capital and the Too‑Big‑To‑Fail subsidy Michael B. Imerman1
© Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract This paper takes a unique approach to study the relationship between bank capital and Too-Big-To-Fail (TBTF) during the Financial Crisis. A structural credit risk model is used to compute implied market value capital ratios which, when compared to traditional riskbased capital, illustrates the capital deficiency of large BHCs. As these BHCs’ implied capital deteriorated, their default probabilities spiked. The model is then used to solve for the amount of capital needed to reduce default probabilities. This amount is compared to the TARP capital infusions to quantify the TBTF subsidy which is associated with size and reliance on short-term volatile funding. Keywords Bank capital · Too-Big-To-Fail · TARP · Structural credit risk model · Bank default probability JEL Classification G01 · G21 · G28 · G32
1 Introduction Despite what we hear about the credit crisis and the problems facing banks, the fact is that the bulk of the U.S. banking industry is healthy and remains well-capitalized. FDIC Chairman, Sheila Bair, October 14, 20081 A common refrain from regulators and bank executives at the start of the Financial Crisis was that financial institutions were “well-capitalized”. Nonetheless, the debate about how much capital banks should have—especially large, systemically important banks—is still ongoing years later. This paper provides a unique look at bank capital during the Financial Crisis through the lens of a structural credit risk model. The model uses stock price and volatility along with detailed data on bank liabilities to solve for a market-implied measure 1
http://www.fdic.gov/news/news/press/2008/pr08100a.html.
* Michael B. Imerman [email protected] 1
Peter F. Drucker and Masatoshi Ito Graduate School of Management, Claremont Graduate University, Claremont, CA 91711, USA
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of bank capital. The market value capital ratio is highly sensitive to default probabilities, which not necessarily a weakness of the analysis and, in fact, may be viewed as a strength in that it provides a dynamic and time-varying measure of bank capital. When market conditions deteriorate and the bank is faced with a challenging liability structure, default probabilities will rise and the market value capital ratio will fall suggesting that the bank needs to de-leverage and recapitalize; however, when market conditions improve and/or the deleveraging and recapitalization process stabilizes, market value capital ratios will rise indicating that the bank is in a better condition. The first empirical evidence presented is that the largest bank holding companies (BHCs) in the United States were well capitalized by regulatory standards. This is consistent with the claims of regulators and bankers, however in market value terms most of them were severely undercapitalized. The fall in market value capital ratios occurr
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