Academic journal article Federal Reserve Bank of New York Economic Policy Review

Evidence from the Bond Market on Banks' "Too-Big-to-Fail" Subsidy

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Evidence from the Bond Market on Banks' "Too-Big-to-Fail" Subsidy

Article excerpt

* Expectations that the government will step in to save the largest banks from failure could create a "subsidy" for these banks by encouraging investors to discount risk when they provide funding.

* A look at bond data over the 1985-2009 period suggests that investors accept lower credit spreads on bonds issued by the largest banks than on bonds issued by small banks.

* The funding advantage enjoyed by the largest banks appears to be significantly larger than that of the largest nonbanks and nonfinancial corporations.

* This evidence is consistent with the idea that "too-big-to-fail" status gives the largest banks a competitive edge.

1. INTRODUCTION

The idea that some firms may be too big to fail appears to go back as far as 1975 in connection with Lockheed Corporation and the financial difficulties experienced by that firm at the time. (1) It was, however, the demise of Continental Illinois Bank in 1984 that provided solid supporting evidence for this idea.

Continental Illinois, which was the seventh-largest U.S. bank by deposits, experienced runs by large depositors following news it had incurred significant losses in its loan portfolio. Concerns that a failure of Continental Illinois would have significant adverse effects on the banks that had deposits with it led regulators to take the unprecedented action of assuring all of Continental's depositors--large and small--that their money was fully protected. (2) Subsequently, during Congressional hearings on Continental Illinois, the Comptroller of the Currency indicated that the eleven largest banks in the United States were too big to fail and would not be allowed to fail. (3)

The perception that some banks will be rescued because they are too big to fail is important because it can have far-reaching implications. If investors, creditors in particular, believe that certain banks are too big to fail, they will discount risk when providing those banks with funding. This insensitivity of financing costs to risk will encourage too-big-to-fail banks to take on greater risk. The largest banks' risk taking, in turn, will drive the smaller banks that compete with them to take on additional risk as well. (4)

That perception has triggered a large body of research attempting to determine whether bank investors, including depositors, believe that the largest banks are too big to fail, and whether those banks behave differently because they expect to be rescued if they get into financial difficulties.

A number of studies have tried to test the too-big-to-fail hypothesis by investigating spreads on bank bonds. Flannery and Sorescu (1996), for example, find that yield spreads on bank bonds were not risk sensitive after the Continental Illinois bailout, suggesting that bond investors believed large banks were too big to fail. However, the authors find that bond spreads came to reflect the specific risks of individual issuing banks starting around 1988 when conjectural guarantees no longer covered (many) bank debentures. Balasubramnian and Cyree (2011) document that the relationship between spread and risk for the largest banks flattened after the rescue of Long-Term Capital Management in 1998. Anginer and Warburton (2014) find a positive relationship between risk and bond spreads in the secondary market but only for midsize and small institutions. Acharya, Anginer, and Warburton (2013) document that bond credit spreads continued to be less sensitive to risk for the largest financial institutions even after the passage of the Dodd-Frank act. (5) Penas and Unal (2004), in turn, focus on bank mergers. They find that bondholders of medium-sized banks that may push the merging bank into the too-big-to-fail category realize the highest returns around the merger and only these banks benefit from some savings when they issue in the bond market after they merge.

Some studies have considered instead credit default swap (CDS) spreads. …

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