A new blog by economists at the Federal Reserve Bank of New York (NY Fed) shows that ratings agencies and financial markets are divided about whether the Dodd-Frank Act has significantly reduced the “too big to fail” problem.
Noting that one of the goals of Dodd-Frank was to end “too big to fail”, the blog points out that to this end, the Act required systemically important financial institutions to submit detailed plans for an orderly resolution (“living wills”) and authorised the Federal Deposit Insurance Corporation (FDIC) to create an alternative resolution procedure.
The response from the FDIC was to create a “single point of entry” (SPOE) strategy, announced in December 2013, in which healthy parent companies bear the losses of their failing subsidiaries.
A natural consequence of this is that parent companies should have become riskier relative to their subsidiaries. As the NY Fed economists point out, this logic is borne out in the rating gap by the major ratings agencies.
Looking at the gap in ratings (parent minus subsidiary) by Fitch, Moody’s, and Standard & Poor’s (S&P) for the four largest bank holding companies (BHC) by assets, the blog shows that this gap has widened for all four banks at all three ratings agencies.
This suggests, explains the blog, that raters perceive that SPOE has increased the risk of the parent relative to that of its subsidiary bank.
“This widening gap coincides with announcements by Moody’s, Fitch, and S&P that SPOE has reduced the expectation of government support for these four BHCs in the event of failure,” it notes.
But examining whether financial markets share this assessment, the blog first looks at how spreads have evolved for a matched pair of bonds – one issued by the parent and one by its bank subsidiary.
“If bond investors agree that SPOE has made the parent riskier, we should see the parent’s option-adjusted spread (OAS) widen relative to that of the subsidiary bank,” it says.
Yet, contrary to the economists’ hypothesis and the views of the ratings agencies, the data shows that the spread gap has not widened consistently for three of the four holding companies; for the fourth, Bank of America, it has actually narrowed.
Nor did the difference in spreads widen noticeably after each of the agencies started to increase the rating gap between parent companies and their bank subsidiaries (points in time marked by vertical lines on the graph below).
The economists at the NY Fed note that this finding could potentially reflect certain frictions in the bond market – illiquidity or market segmentation, for example. However, they also observe a similar result in the credit default swap (CDS) market.
“The difference in CDS spreads (parent minus subsidiary) has not increased persistently since the SPOE was announced. A temporary increase in this difference emerged in July 2016, but that gap has since closed. Overall, we do not see the kind of persistent increase in the difference in spreads that would support the rating agencies’ view that parent companies have become riskier relative to their subsidiaries,” observes the blog.
Thus, the empirical evidence suggests that there remains a difference of opinion regarding the effectiveness of the SPOE between the ratings agencies and the market.
The blog concludes: “It’s possible that investors are still skeptical about the new resolution tool since it has not yet been tested. It’s also possible that bond markets’ perceptions of risk differences between parent and subsidiary banks are concealed by the generally strong financial condition of the four institutions that we consider. Nonetheless, the absence of a market response is notable.”