Measuring the 'Too Big to Fail' Effect on Bond Pricing



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Do the biggest banks have a bond funding edge?

“Too big to fail” (TBTF) represents, among other things, the idea that the biggest US banks receive an unfair funding advantage over smaller banks in the bond market. Recent research has shown a sizeable advantage, but our empirical work suggests otherwise. Within the universe of bond-issuing US banks, the six largest banks did indeed experience a slight funding advantage – of just 6bp on average – from 1999 until the financial crisis began in mid-2007. The advantage widened sharply during the crisis, but then reversed to a significant funding disadvantage for most of 2011 and 2012. Today, the bonds of these six banks still trade at a roughly 10bp disadvantage to the bonds of other banks.

Behind the differences in TBTF findings

Our findings differ from prior research in large part because other studies have tended to analyze an overly broad universe of bond issuers, including non-bank financials and non-US firms from a wide range of countries. Because the funding advantage is greater for non-bank financials than for banks, the effect of using a larger dataset is to inflate the funding advantage attributed to the largest US banks. This research also often fails to consider that the largest firms in most industries receive a bond funding advantage relative to smaller firms, one that is typically greater than the advantage seen in banking. This oversight seriously undermines the notion that government support drives a TBTF funding advantage.

Liquidity and historical loss data support a funding advantage

We find that the bonds of the largest banks provide investors with far greater liquidity, and that this added liquidity can in itself explain the funding advantage that the largest banks have at times experienced. We also find, through a careful examination of historical FDIC data, that the largest US banks generate fewer realized losses than do the failures of smaller banks per dollar of deposits. When the largest banks encounter trouble, as they certainly do at times, their direct financial losses are generally borne by their shareholders or creditors. TARP clearly illustrates this dynamic: the government made a 15% profit on its assistance to the six largest banks and diluted their shareholders by at least 5% to as much as 82%. In contrast, more than 400 small banks have yet to repay their TARP funds in full, and 40% of those that have repaid have relied on other sources of government funding rather than their own resources.