The end of market discipline? Investor expectations of implicit state guarantee

We find that bondholders of major financial institutions have an expectation that the government will shield them from large financial losses and, as a result, they do not accurately price risk. Using bonds traded in the U.S. between 1990 and 2012, and using alternative approaches to address endogeneity, we find that bond credit spreads are sensitive to risk for most financial institutions, but not for the largest institutions. This expectation of government support constitutes a subsidy to large financial institutions, allowing them to borrow at lower rates. Recent financial regulations that seek to address too-big-to-fail have not had a significant impact in eliminating expectations of government support.

“This paper is part of the mini conference on "The Future of Large Financial Institutions" at the 2014 fall meetings of the International Atlantic Economic Society.  Sessions on this and related themes are expected to be continued at the spring 2015 meetings in Milan and the fall 2015 meetings in Boston.”