What Can Volatility Smiles Tell Us About the Too Big to Fail Problem?
forthcoming in the Journal of Financial and Quantitative Analysis
62 Pages Posted: 13 Jul 2021 Last revised: 6 Sep 2022
Date Written: September 1, 2022
We exploit the information content of option prices to construct a novel measure of bank tail-risk. We document a persistent increase in tail-risk for the U.S. banking industry following the global financial crisis, except for banks designated as systemically important by the Dodd-Frank Act. We show that this post-crisis difference in tail-risk for large and small banks is consistent with the too-big-to-fail (TBTF) status of large banks being reinforced by the Dodd-Frank designation: Naming the banks whose failure could threaten the financial stability of the U.S. gave investors a list of banks the government deemed as TBTF.
Keywords: too-big-to-fail, volatility smile, implicit guarantees, bank regulation
JEL Classification: G01, G20, G21, G28
Suggested Citation: Suggested Citation