The “Too Big to Fail” theory states that some financial institutions are so large that their failure will have a terrible effect on the national economy. Therefore, in the event of a severe challenge, the government bails them out. Large companies usually have business relations with small companies for services and supplies. If the large company fails, the smaller company’s business would also be adversely affected.
During the financial crises, the U.S and U.K governments announced bailout packages worth $600 billion. In the US, JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp (NYSE:BAC) , Citigroup Inc (NYSE:C), Wells Fargo & Co (NYSE:WFC), Goldman Sachs Group, Inc. (NYSE:GS) and Morgan Stanley (NYSE:MS), which are perceived as the six largest banks, received bailouts.
However, the stability of the financial sector has a trade off. While the regulators want stability, investors want profitability. The small-loan business sector is covered 60% by community banks and the remaining 40% by megabanks; this small-business loans segment represents 5% of the total megabank lending.
Stringent capital requirements hurting profitability
Banking regulations related to a robust capital base have a more severe impact on smaller banks as compared to the largest banks. While the need to hold additional capital hurts a bank’s lending abilities, it creates sustainability issues for the smaller players. The upcoming Basel III regulations would require banks to maintain a specific amount of capital and liquidity standards, which is higher than previous standards.
New regulations are being introduced so that the banking sector can absorb any financial or economic stress. It is easy for a large bank to maintain this capital, but looking at community banks they already have a very small capital base, which would impact their profitability. The Basel committee’s first two versions failed to avoid the financial crises. Banks with assets of less than $10 billion control 20% of the total U.S banking assets.
At the end of the first quarter of 2013, JPMorgan reported strong earnings, and an estimated Basel 3 Tier 1 common ratio of 8.9%, up from the prior quarter’s 8.7%. Its Basel 1 tier 1 ratio came in at 10.2%. Wells Fargo & Co (NYSE:WFC)’s reported 10.4% Tier 1 common equity ratio under Basel 1 and estimated a Tier 1 common equity ratio of 8.4% under Basel 3. Similarly, Bank of America Corp (NYSE:BAC) reported a Basel 1 tier 1 ratio of 11.2%, up 43 basis points year-over-year, and an estimated Basel 3 ratio of 9.5%.
In addition, if Basel 3 capital and liquidity conditions are volatile and increase costs for banks, then the banks may pass cost increases to corporate clients.
Race for low cost of funds
Regulators’ dreams of a stable financial system have led to a race to tap cheaper sources of funding amongst banks. Currently, big banks have a heavy reliance on wholesale funding to finance their regular operations, but is wholesale funding actually cheap?
Big banks have to pay lower interest on their bond issues largely because they are bailed out in case of a default. Besides, the largest banks have greater financial needs; their bond issues are bigger and more liquid. Therefore, the bonds issued by largest banks are considered safer by bond investors.