Something unusual happened during today's Senate Banking Committee hearing featuring Federal Reserve Chairman Ben Bernanke. Democrats and Republicans actually agreed on something!
Virginia Senator David Vitter (a Republican) and outspoken Massachusetts Senator Elizabeth Warren (a Democrat) hounded Mr. Bernanke about the risk too-big-to-fail financial institutions still pose to the broader economy.
Senator Warren referenced a recent study by an International Monetary Fund economist that suggested the market's expectation of a U.S. federal bailout is allowing megabanks to receive cheaper funding compared to smaller, regional banks that would be allowed to fail. The study estimates the implicit subsidy is worth around $83 billion annually to the 10 largest U.S. banks, measured by assets.
The thought of members of Congress agreeing that any possibility of a bailout should be completely off the table may make investors in Bank of America (BAC -0.21%), Wells Fargo (WFC -0.03%), and JPMorgan Chase (JPM 0.06%) think twice about having one of these behemoths as a long-term holding. However, it is important to remember the difference between political rhetoric and the possibility of substantive changes to these banks.
European banks safer than U.S.?
While Bernanke acknowledged the market's bailout expectation for large U.S. banks, he was quick to note that despite the mounting troubles in European banks, U.S. banks have actually seen wider credit default spreads (a proxy for the risk of debt default) than their European counterparts because of the even higher assumed probability that European governments would bail out its troubled lenders. Bernanke agreed the goal should be to diminish the market's expectation of a federal bailout and level the playing field for small lenders.
Bernanke and his colleagues at the Fed must strike an interesting balance when it comes to these large institutions that undoubtedly still pose an enormous risk to the broader domestic and global economy. Through reforms set forth by the Dodd-Frank Wall Street Reform Act, these megabanks are required to produce living wills and detailed steps to follow if the bank were to fail.
Ben knows best
Members of the Senate Banking Committee suggested several times that the Fed should require additional capital be held beyond the Basel 3 and Systematically Important Financial Institution (or SIFI) buffers already proposed. In actual practice, severe capital requirements on these institutions that are not globally agreed upon could significantly hinder these American institutions' ability to compete in the global marketplace and would hurt return on equity.
While picking on big banks is a surefire way to rile up these Senators' constituencies, Bernanke and the market understand the importance of these banks if the American economy is going to consistently show improvement. In the coming weeks, as the Federal Reserve releases U.S. bank stress results on March 7 and Comprehensive Capital Analysis Review (or CCAR) outcomes on March 14, I expect investors will continue to see these banks showing impressive capital ratios. With shares of Bank of America and Wells Fargo both up after the hearing, it's clear the market realizes the Senate Banking Committee is much more bark than bite.
