Does Banks' Size Distort Market Prices? Evidence for Too-Big-To-Fail in the CDS Market

Abstract

This paper examines the potential distortion of prices in the CDS market caused by too-big-to-fail. Overall, we find evidence for market discipline in the CDS market. However, CDS prices are distorted due to a size effect which arises when investors expect a public bail-out as a result of too-big-to-fail. A one percentage point increase in size reduces the CDS spread of a bank by about two basis points. We further find that some banks have already reached a size that makes them too-big-to-be-rescued. While the price distortion for these banks decreases the existence of banks that are considered to be toobig-to-rescue raises important new issues for banking supervisors.Keywords: Market Discipline, Too Big To Fail, Too Big to Rescue CDS Spreads JEL: G14, G21, G28 Non-echnical summaryThe information content of banks' security prices assumes an increasingly larger role in supervisory monitoring. The interest in this issue is twofold. Investors that share the business risk of banks have an incentive to discipline the business activities of a banks' management. They can exercise direct market discipline through an adjustment of refinancing conditions. If market prices reflect banks' riskiness supervisors can use this information to exert indirect market discipline.The general consensus in the academic literature is that security prices adequately reflect risks of the underlying bank. However, an important concern is that banks' security prices may be distorted when a bank becomes large enough to threaten overall financial stability and a public bail-out becomes likely. These banks are called "too-big-to-fail" banks (TBTF). Consequently, investors are less concerned about the failure of a TBTF bank given that losses are limited which reduces their incentive to exercise market discipline. This paper examines the information content of CDS spreads for a sample of 91 banks from 24 countries. CDSs have gained increasing prominence in the derivative market and have become a core instrument for the transfer of risk. Additionally, several papers show that CDS markets reflect new market information more rapidly than bond markets and that they are also leading indicators such as ratings. For these reasons, CDS spreads have become an important tool for supervisory risk assessment.Overall, we find that CDS spreads reflect banks' risk. However, we further detect an important size effect that vindicates the existence of a distortion due to toobig-to-fail. A one percentage increase in the mean size of a bank relative to the home country's GDP reduces the CDS spread by about two basis-points. While this appears small, one has to keep in mind that mergers can involve substantially larger increases in size.In addition, our results confirm that some banks may already have reached a size that makes them too-big-to-rescue. In other words, we find that the distortion of CDS spreads declines for banks beyond a threshold size of about 10 percent market capitalization relative to the home country's GDP.

The determinants of bank CDS spreads: evidence from the financial crisis

“…Blanco et al (2005), Zhu (2006), Alexopoulou et al (2009), andNorden andWeber (2009) show that the CDS market leads the corporate bond market in terms of price discovery. Volz and Wedow (2010), Constantinos (2010), Flannery (2010), Norden and Weber (2010) find that CDS markets convey information on banks' default risk that is suited to play an important role in enhancing market discipline. In particular, they believe that the CDS market is of particular importance for banking supervisors.…”

The IMF As a Biased Global Insurance Mechanism: Asymmetrical Moral Hazard, Reserve Accumulation, and Financial Crises

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