What Can Volatility Smiles Tell Us about the Too Big to Fail Problem?

51 Pages Posted: 5 Aug 2019 Last revised: 17 Sep 2019

See all articles by Diego Puente M.

Diego Puente M.

Australian National University (ANU)

Date Written: September 16, 2019

Abstract

This paper exploits the information content of option markets to offer fresh insight into the Too-Big-to-Fail (TBTF) problem for banks. I employ option prices to construct a forward-looking measure of bank exposure to significant price drops (i.e. tail-risk) and explore cross-sectional differences between large banks with at least $50B in assets identified as systemically important and smaller banks. I document a permanent increase in the average tail-risk of the U.S. banking industry as a whole following the Global Financial Crisis (GFC), except for banks above the $50B size threshold. I argue that the stark post-crisis difference in tail-risk for banks above and below the $50B threshold is consistent with the notion that the TBTF status of above 50B banks was reinforced by the series of bailouts targeted at them during the crisis and their subsequent designation as systemically important by the Dodd-Frank Act. This in turn raised investor expectations of future bailouts for above 50B banks and reduced their perceived exposure to downside risk as captured by the tail-risk measure.

Keywords: too-big-to-fail, volatility smile, implicit guarantees, bank regulation

JEL Classification: G01, G20, G21, G28

Suggested Citation

Puente Moncayo, Diego, What Can Volatility Smiles Tell Us about the Too Big to Fail Problem? (September 16, 2019). Available at SSRN: https://ssrn.com/abstract=3430170 or http://dx.doi.org/10.2139/ssrn.3430170

Diego Puente Moncayo (Contact Author)

Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

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