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Are Banks still ’Too Big to Fail’? – A market perspective

Summary:
Nicole Allenspach, Oleg Reichmann and Javier Rodriguez-Martin in this Swiss National Bank paper: This paper aims at deriving the market’s assessment as to whether banks worldwide still benefit from a Too Big To Fail (TBTF) subsidy. Such a subsidy reflects the market’s expectation of government support in the event of a crisis and results in reduced funding costsfor the benefiting bank. To capture this effect, we use two different extensions of the Merton (1974) framework. We find that large banksbenefit from a TBTF subsidy, while large nonfinancial firms do not. This subsidy has declined somewhat since the Global Financial Crisis(GFC) but remains larger than before the crisis. These conclusions also hold when considering Contingent Convertible (CoCos) and bailin bonds as fully

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Nicole Allenspach, Oleg Reichmann and Javier Rodriguez-Martin in this Swiss National Bank paper:

This paper aims at deriving the market’s assessment as to whether banks worldwide still benefit from a Too Big To Fail (TBTF) subsidy. Such a subsidy reflects the market’s expectation of government support in the event of a crisis and results in reduced funding costs
for the benefiting bank. To capture this effect, we use two different extensions of the Merton (1974) framework. We find that large banks
benefit from a TBTF subsidy, while large nonfinancial firms do not. This subsidy has declined somewhat since the Global Financial Crisis
(GFC) but remains larger than before the crisis. These conclusions also hold when considering Contingent Convertible (CoCos) and bailin bonds as fully loss-absorbing. Moreover, we find differences in the TBTF subsidy across jurisdictions and provide evidence that these can to a large extent be explained by differences in bank health.

They also find TBTF subsidy appears to be more pronounced in Europe:

Second, over most of the period considered, the TBTF subsidy appears to be more pronounced in Europe than in the US. We show that in the
CreditGrades model, a large part of this differential is statistically explained by the US banks’ better “health”, as reflected by their higher leverage ratios and standalone ratings. Nevertheless, there remains a small but increasing differential in favour of European banks since 2017 after controlling for these factors. One cannot rule out at this stage that the market perceives US banks as less likely to be bailed out, other things being equal. This could be the case if, for instance, the market perceived resolution policies in the US as more effective than in Europe.

Third, in times of calm, the interpretation of low indicator values is ambiguous. On the one hand, a low value may imply that the market assesses government support of the bank in the event of a crisis as unlikely. On the other hand, the market may assess the probability that the bank will suffer from financial distress, and, hence, the probability that the bank will actually need financial support, as low. The probability of government support in case of a bank crisis and the probability of such a bank crisis cannot be disentangled as the indicator value is the product of both.4,5 Because of this identification problem, authorities should not exclusively rely on such TBTF indicators when periodically reviewing the TBTF issue, but rather use them in combination with expert judgement

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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