The End of Market Discipline? Investor Expectations of Implicit State Guarantees

Abstract:     
We find that bondholders of major financial institutions have an expectation that the government will shield them from losses and, as a result, they do not accurately price risk. While bond credit spreads are sensitive to risk for most financial institutions, credit spreads lack risk sensitivity for the largest institutions. This expectation of public support constitutes a subsidy to large financial institutions, allowing them to borrow at government-subsidized rates. The implicit subsidy provided large institutions an annual funding cost advantage of approximately 28 basis points on average over the 1990-2010 period, peaking at more than 120 basis points in 2009. The total value of the subsidy amounted to about $20 billion per year, topping $100 billion in 2009. Passage of Dodd-Frank did not eliminate expectations of government support. The cost of this implicit insurance could be internalized by imposing a corrective tax. Requiring financial institutions to shoulder the full cost of their debt would help create a more stable and efficient financial system.

Number of Pages in PDF File: 45

Keywords: Banking, too big to fail, too-big-to-fail, TBTF, financial institutions, financial crisis, safety net subsidy, bailout, implicit subsidy, implicit guarantee, government guarantee, public guarantee, state guarantee, asymmetric guarantee, conjectural guarantee, moral hazard, systemic risk

JEL Classification: G21, G24, G28

working papers series