So I thought this article was pretty opaque. They didn't really discuss the subsidy enough. They just said there was a subsidy that allowed the banks to borrow money at a reduced rate. Who is giving them this preferential treatment? How do those particular banks get that subsidy? Why not charge all banks the same rate and let the size of these banks eat themselves. It's not a hard concept to swallow if you've had economics 101. Law of diminishing returns which happens to any business when it gets too large. But, I think it didn't really layout a case for why this subsidy exists.
The subsidy discussed is not an issue of economics directly, but capital markets, i.e. finance.
The paper infers a subsidy level for state-supported financial institutions by comparing the level of state support embedded in credit agency ratings and comparing them to their long-run average value. The authors control for the factors such as the sovereign's own ability to support, because sovereign debt is also rated by agencies, and for institutions intrinsic rating values.
Credit ratings are used directly and indirectly by capital market participants to determine the level of funding costs across all debt markets. So, they are the best available proxy for determining at least a floor for this preferential rate. As can be seen from previous financial crises, actual bailouts would be highly dependent on the nature of crises and may be substantially higher than expected.
How do those particular banks get that subsidy?
- from other market participants. In a sense, governments are permitting the misallocation of capital from other market participants, including governments and government agencies (hence taxpayers are directly involved), into the state-supported institutions. It is not a zero-sum game because of how that capital is then used.
Why not charge all banks the same rate and let the size of these banks eat themselves.
- there is no central rate allocation. Market participants use market prices and their best available information for funding costs. A state-supported institution is naturally considered by many participants to be a lower risk than a non-state supported institution.
I get the feeling the author of that piece didn't quite understand what the "subsidy" represented, hence why the author didn't explain it very well. If I can sum up what you said these bigger banks get better credit ratings because rating agencies give them better ratings because of their size and perceived safety. Overtime these small changes give them an edge in lending rates.
It's not a real subsidy. They're saying that by allowing banks to get too big to fail, the banks are in a sense using the assets of the federal government as if they owned them. Everyone knows the feds will bail them out, so they can borrow money more cheaply than they would be able to otherwise.
Law of diminishing returns doesn't work like that (they're not adding just a single factor of production), and you're fighting against economies of scale (which are also economics 101).
