What do Banks Gain From Being Too Big to Fail?

(MoneyWatch)  Of the U.S. financial companies the federal government has decided are "too big to fail," how much of their 2009 profits owe to being able to borrow funds more cheaply than smaller lenders? More than is commonly thought, concludes the Center for Economic and Policy Research.

For a banking giant like Wells Fargo, it can amount to as much as one-quarter of the company's $18.7 billion in profits reported through the second quarter. For Bank of America, it may account for 46 percent, while more than all of Capital One's earnings may derive from this indirect subsidy, according to the Washington think tank (click on chart to expand).

Because they're effectively backed by the full faith and credit of the government, these big financial players pay a lower interest rate to obtain deposits and borrow other funds. After the feds started bailing out the TBTF crowd in late 2008, the spread between the average cost of funds for institutions with at least $100 billion in assets and for smaller banks has risen to 0.78 percentage points. That's up significantly, from 0.29 points, in the period from early 2000 to the start of the economic recession in late 2007.

That gap amounts to a roughly $34 billion government subsidy to the 18 largest bank holding companies. Says the CEPR:

The numbers. . . suggest that to a large extent the recent rise in the profitability of the TBTF banks may be attributable to the fact that they enjoy the protection of the government's backing at a time when the banking system as a whole continues to experience substantial strains. This should concern policymakers, since it would imply that a substantial portion of the profits of the largest banks is essentially a redistribution from taxpayers to the banks, rather than the outcome of market transactions.

As the group concedes, other factors beyond lower borrowing costs related to an implicit government backstop may contribute to this advantage enjoyed by large financial firms. The interest rate gap also may be temporary, reflecting ongoing economic uncertainty. And for now there's no empirical proof that the lower borrowing costs for big firms results from their status as "systemically important."

The real test will be whether this tilt in the playing field levels out once the financial markets stabilize and rates return to normal. If not, then taxpayers will essentially be financing a huge competitive advantage for the nation's biggest financial players.