3 Reasons Why The Banking System Might Actually Be Safer

While many think the flurry of reforms that followed the financial crisis did little to make the system more stable, the Treasury Department argues that it really is different this time.

Coming up on the five year anniversary of the failure of Lehman Brothers and the worst of the financial crisis, has Wall Street gotten any safer for taxpayers? Anat Admati, a Stanford professor and one of the leading advocates for much stricter regulations on how much banks are allowed to borrow, best summed the opposing view when she wrote in The New York Times last month that "nearly five years after the bankruptcy of Lehman Brothers touched off a global financial crisis, we are no safer."

The Obama administration has a different story.

In a briefing with reporters yesterday, a senior Treasury official said that "Wall Street reform is intended to end any concept that a large financial institution will be rescued or that taxpayers will be put on the hook for one in a financial crisis." The official put forward three arguments for why the financial system as a whole is safer, more stable, and that investors are finally getting the message that the government really won't bail out a big bank should it face failure.

1. The biggest banks are paying more to borrow money.

Treasury Department

While there isn't exact agreement on what "too big to fail" means, one crucial part of it is the expectation that lenders to large banks—and the biggest banks borrow a ton of money—will not face any losses in a financial crisis. Although many dispute it, Treasury claims that the market has responded to regulations and procedures put in place in the Dodd-Frank financial reform bill to ensure that bank stockholders, lenders, and executives won't get bailed out.

This chart shows how much banks have to pay to borrow money for five years compared to a five year government bond. The six biggest investment and commercial banks, as shown in this chart, have seen their borrowing costs, on average, go up about .75% since before the financial crisis. Large regional banks, which are generally considered small enough to fail, have seen their borrowing costs only go up only .4%.

If the market took the end of too big to fail seriously, you'd expect the borrowing costs of the biggest banks to go up considerably more than that of the smaller banks that never had the expectation of a bailout. The senior Treasury official described the difference in borrowing costs as "some evidence that the marketplace recognizes that the cost of these large institutions needs to be priced into these securities.”

2. Bank borrowing is getting more long term

Treasury Department

What really screwed big banks, especially investment banks like Lehman Brothers (now bankrupt), Bear Stearns (bought for a song by JPMorgan), and Merrill Lynch (acquired by Bank of America in a shotgun wedding), was their reliance on very short term loans to fund their business day-to-day.

Bear Stearns, for example, borrowed some $70 billion daily. When that money dried up because of worries about losses it faced thanks to mortgage-backed securities, it faced either bankruptcy or a quickie sale. If the banking system wants to avoid a repeat of 2008, then it has to start depending more on longer term debt.

Right before the financial crisis, some 60 percent of the banking system's assets were funded by money borrowed for less than a year, meaning that banks could be driven into bankruptcy if those short-term borrowers got spooked—even if they had lots of cash on hand. That number is now below 40% and has been trending steadily downward since the financial crisis.

3. Banks are borrowing less

Treasury Department

This chart shows the amount of bank assets—mostly their loans—that are funded with "Tier 1 capital." The chart basically measures how much a bank is borrowing compared with how risky its assets are. Thanks to new international rules, banks are now required to fund more of their business with stock as opposed to debt than they were before the financial crisis.

This matters because when banks do run into trouble, they are still legally obligated to make payments to their lenders, while stockholders have no such legal claim. So, if banks borrow less and sell more stock to fund themselves, they become more resilient to large losses.

On top of the new international rules which are going into effect, U.S. regulators have proposed their own stricter rules that would mandate the parent companies of the largest American banks fund no more than 95 percent of their total assets with debt, with no adjustments for how risky those assets are.