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

Abstract

Using unsecured bonds traded in the U.S. from 1990 to 2020, we examine the sensitivity of credit spreads to changes in firm risk. In the time period preceding the implementation of the Dodd-Frank Act, we find that credit spreads were less sensitive to risk for large financial firms compared to small financial firms and compared to large non-financial firms. This lack of spread-risk sensitivity is consistent with investors expecting government guarantees on unsecured debt of large financial firms. In the post-Dodd Frank period after 2012, we do not observe differences in this sensitivity by firm size. These results are consistent with a strengthening of market discipline in the aftermath of the policy reforms implemented following the financial crisis.

Keywords: Too big to fail, financial crisis, Dodd-Frank, bailout, implicit guarantee, moral hazard, systemic risk

JEL Classification: G21, G24, G28