RISKY BUSINESS: THE FUNDING ADVANTAGES OF TOO-BIG-TO-FAIL FINANCIAL FIRMS

Abstract

The most recent financial crisis demonstrated that some financial firms are so large and systemically essential that their failure can become catastrophic to the entire economy. Financial markets may presume such firms are “too-big-to-fail” and will be rescued by government aid, bailing out the firm’s stakeholders. Many believe this market presumption permits these institutions to finance themselves on advantageous terms, inappropriately subsidizing excessive growth and risk taking. This paper advances the existing literature regarding whether such a “too-big-to-fail” subsidy exists and how large the subsidy may be. Relying on a measure of credit risk specifically tailored for financial institutions that has not been used in other research, this paper seeks to more accurately estimate the impact of market expectations of government support. By extending the data through 2013 and utilizing a number of tests of endogeneity, this paper also seeks to alleviate a number of concerns regarding previous work. The results of this research suggest that an economically large and statistically significant subsidy exists in corporate bond markets benefitting systemically important financial institutions. The subsidy reached historic levels in 2008 and 2009 at the height of the financial crisis, and then declined to pre-crisis levels after the passage in 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This thesis concludes by explaining the ways in which it may be premature, however, to definitively say whether the decline reflects a genuine reduction in the market’s perception of the likelihood of government support of systemically essential financial firms