PDF Ebook The Effect of TBTF Deregulation on Bank Cost of Funds
The purpose of this paper is to determine the impact of the Federal Deposit Insurance Improvement Act of 1991 (FDICIA) and the National Depositor Preference Law of 1993 on the cost of non-deposit liabilities. In particular, we compare the average cost of funds and market values of large banks to that of small banks to determine whether restrictions to the much criticized “too-big-to-fail” (TBTF) policy increased the risk and hence the required rates on large bank deposits. Secondly, we examine the cost and proportion of non-deposit funds in large banks before and after the passage of the Omnibus Budget Reconciliation Act of 1993 (OBRA93) to determine whether the preference law increased the risk and cost of these funds for banking institutions.
The banking literature suggests that deposit insurance, and especially the traditional use of the TBTF doctrine in large bank failures introduced wealth effects directly through a deposit-linked subsidy. Under the policy, all depositors (insured and uninsured) in large banks were implicitly insured beyond the $100,000 limit. The accompanying reduction in risk premium required by depositors amounted to a subsidy which directly increased profits and market values. However the new limits on TBTF may increase the likelihood of deposit loss, causing uninsured depositors to require a higher interest compensation. There is also an indirect effect stemming from increased risk-taking incentives under the previous too-big-to-fail policy. The 100% deposit coverage eliminated the incentives for depositors to be more sensitive to the financial soundness of their banks. As a result, a shareholder-wealth maximizing TBTF-bank had the incentive to increase portfolio risk and thus increase expected profits. One possible result is that an unexpected announcement of the TBTF option during a particular bank failure will cause an upward revision of share prices of covered banks. Under the new restrictions, however, uninsured depositors are expected to be at a greater risk of loss. This should make them more sensitive to the financial soundness of their banks, and in turn reduce the banks’ ability to increase risk. The impact of the new limits on TBTF could therefore be to reduce depositor risk, causing the bank cost of borrowed funds to decline (rather than increase).
The impact of FDICIA, and in particular the amendment to TBTF, on the cost of funds may depend on its interaction with the National Depositor Preference Law of 1993. The preference statute was passed as an amendment to FDICIA to minimize the potential loss to the FDIC during a bank failure. The key feature of the statute was the enhancement of the priority of insured and uninsured depositors’ claims and an increase in the risk of loss for general non-deposit creditors of banking institutions. With increased risk of loss, the cost of these funds are likely to increase as general creditors demand higher interest compensation.
This paper has three objectives. First, we examine the impact of TBTF restrictions on the cost of funds of commercial banks. As discussed above, if these restrictions increased the risk of deposit loss, we should observe an increase in deposit costs as depositors require higher interest compensation. Conversely, bank risk might decline under increased monitoring, causing bank deposit rates to decline. Secondly, we examine the impact of the depositor preference statute on bank cost of funds. To the extent that changes in the order of depositor priority adversely affect the risk of non-deposit creditors, the cost of these funds will increase. On the other hand, if general creditors respond to protect their claims, the proportion and cost of non-deposit funds may decline. This could increase the risk and cost of deposits, contrary to the objectives of the preference statute. Finally, we examine the changes in market values of commercial banks relative to the changes in TBTF and depositor priority to determine whether these changes had any wealth effects and how the effects were distributed by bank size.
The organization of the paper is as follows. In section 2, we provide some background on the scope and potential impact of the legislative initiatives for ending “too-big-to-fail” and restructuring the order of priority of liabilities in a bank. In section 3, we discuss the implications of these legislative changes for bank cost of funds and market values, and we outline the hypothesis to be tested. We describe the sample used in section 4. Section 5 discusses the results and section 6 concludes the paper.
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PDF Ebook The Effect of TBTF Deregulation on Bank Cost of Funds
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