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POLITICS: PennAve

New York Fed: Megabanks are too big to fail, and engage in more risk-taking

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Finance and Banking,PennAve,Joseph Lawler,Economy,Federal Reserve,Janet Yellen,Dodd Frank

The Federal Reserve Bank of New York issued a study Tuesday concluding that the largest U.S. banks are perceived by investors to enjoy an implicit guarantee from the government, and another report finding that the biggest banks engage in riskier activities.

The question of whether the largest "too-big-to-fail" banks would pose a threat to the financial system and economy if they failed has been a hotly debated question since the financial crisis, and a pointed one for regulators since the passage of the Dodd-Frank financial reform law in 2010 intended to prevent future bailouts from the risky activities that implicit government guarantees are thought to encourage.

The study released by the New York Fed will not answer that question, because it includes data only through 2009, before the passage of Dodd-Frank. Obama administration officials maintain that Dodd-Frank includes the tools necessary to prevent banks from gaining too-big-to-fail status.

Nevertheless, the study, written by economist João Santos, finds that the largest U.S. banks did enjoy a lower cost of borrowing than both smaller banks and comparably sized nonbanks, suggesting that they enjoy an implicit funding subsidy thanks to investors' belief that they would be bailed out in case of a failure.

In a separate report including more up-to-date data, however, the New York Fed found that big banks thought of as more likely to receive government support do engage in more risk-taking. Santos, Gara Afonso and James Traina examined examples of risky lending by banks regarded by the ratings agency Fitch to benefit from a government safety net and found "novel evidence that government support does play a role in bank risk-taking incentives."

The studies are part of a larger effort by the New York regional Fed bank to examine the workings of big banks.

In a recent press conference, Federal Reserve Board Chairwoman Janet Yellen said that "strengthening the financial system is a work in progress," and added that "it's high priority for me, to see further work done in addressing too big to fail."

Tuesday's studies from the New York Fed likely won't sway regulators on the question of too-big-to-fail. The Government Accountability Office, however, is expected to release a report later this year on the subsidies -- if any -- received by financial institutions perceived as too-big-to-fail, and that study is likely to prove more important in setting the agenda.

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