Do Bond Investors Price Tail Risk Exposures of Financial Institutions?

Abstract

We analyze whether bond investors price tail risk exposures of financial institutions using a comprehensive sample of bond issuances by U.S. financial institutions. Although primary bond yield spreads increase with an institutions' own tail risk (expected shortfall), systematic tail risk (marginal expected shortfall) of the institution doesn't affect its yields. The relationship between yield spreads and tail risk is significantly weaker for depository institutions, large institutions, government-sponsored entities, politically-connected institutions, and in periods following large-scale bailouts of financial institutions. Overall, our results suggest that implicit bailout guarantees of financial institutions can exacerbate moral hazard in bond markets and weaken market discipline.

Keywords: Financial Institutions, Moral Hazard, Market discipline, Implicit Guarantee, TBTF, Too-big-to-fail, Bailout, Tail risk

JEL Classification: G21, G22, G24, G28