Study Puts Price Tag on ‘Too Big to Fail’

LONDON - An analysis commissioned by the Green Party in the European Parliament estimates that the cost of the implicit guarantee that governments will back large financial institutions, known as “too big to fail,” was about 234 billion euros in 2012.

To remedy the distortions of this subsidy, policy makers should go further in carving out the risky parts of banks, demand that the banks hold even heftier capital cushions and tax any remaining advantage, said Philippe Lamberts, a Green Party member of the European Parliament who commissioned the study.

“It is urgent to eliminate the market advantage given to these institutions,” said Mr. Lamberts, who added that he commissioned the study to provide evidence for coming banking reform legislation.

Alexander Kloeck, the author of the study and an independent consultant, said the problem with the implicit guarantee was that it created distortions in financial markets. “It’s a free guarantee the institutions benefit from,” he said on a conference call with reporters. It creates moral hazard, or the willingness of banks to take outsize risk, knowing there is a lender of last resort, he said.

The €234 billion figure was reached by looking at eight academic and institutional studies focused on implicit subsidies. “We’ve taken everything we could find and tried to extract a meaningful average out of it,” Mr. Kloeck said.

Most of the studies arrive at a figure by quantifying the lower lending costs that large financial institutions enjoy from the market because of governments’ willingness to prop up failing national financial institutions, called the funding advantage approach. Others use a more complex option-pricing theory model.

The study comes as policy makers are focused on the health of Europe’s banks and their role in aiding or hindering Europe’s economic growth. The European Central Bank is examining the books of European banks this year in an attempt to uncover any serious problems. Unveiling toxic assets, the hope is, would help to restore faith in balance sheets and allow European banks to start lending again.

At the World Economic Forum meeting in Davos, Switzerland, last week, Mario Draghi, president of the European Central Bank, said he did not know whether any banks would need to be closed as a result of the central bank’s examination but that the system was prepared to deal with the consequences if any significant problems materialized.

“The banks that should go, should go,” Mr. Draghi said.

Regulators in the United States, Britain and Europe have scrambled to enact rules aimed at better monitoring of bank balance sheets. Last year, Britain passed legislation that separated retail banking from riskier investment banking and made it easier to hold senior executives accountable for reckless behavior.

Sajid Javid, financial minister to the British Treasury, told The Financial Times last December that the bill would reduce the risk of too big to fail, but he said it was impossible to completely insure against future state bailouts. British taxpayers had to rescue the Royal Bank of Scotland and the Lloyds Banking Group in 2008-2009.

In the United States, the Volker Rule bans proprietary trading by banks. Stricter capital requirements from the so-called Basel III accords will require banks to hold larger capital reserves to insure against losses. With the European Commission set to take up structural banking reform this year, Mr. Lamberts said he was looking for evidence to bolster tougher reforms.

Mr. Lamberts is familiar to those in Britain and Europe as one of the primary authors of the bill to limit bankers’ bonuses to 100 percent of fixed salary, or 200 percent if approved by shareholders. Britain has challenged that bill in the European Court of Justice. He is also a proponent of a financial transaction tax and a supporter of limits on short-selling that were upheld by the European Court of Justice last week.

Mr. Lamberts acknowledged that his policy recommendations â€" further ring-fencing, higher capital cushions and increased taxes â€" could make credit more expensive at a time when economic recovery is weak.

“I don’t want to make credit more expensive,” he said. “I want markets to pay the real price of credit, and I don’t want taxpayers to subsidize credit for everyone.”

According to European Central Bank figures cited in the too big to fail analysis, European Union banks as a whole lost €29.4 billion in 2012, while large banks posted profits of €16.2 billion.

“These figures clearly show that without the implicit subsidies the large banking institutions in the E.U. would be making substantial losses,” the study said.