Are Banks Too Big to Fail or Too Big to Save?
In the years leading up to the current financial crisis, banks around the world expanded their balance sheets to increase profitability in an environment of cheap funding. Access to international funding made it possible for individual banks and overall banking systems to reach enormous size relative to their countries' GDP. The prime example is Iceland where the liabilities of the overall banking system reached around 9 times GDP at the end of 2007, before a spectacular collapse of the banking system in 2008. By the end of 2008, the liabilities of publicly-listed banks in Switzerland and the United Kingdom had reached 6.3 and 5.5 times their GDP. Liabilities of banks in Belgium, Denmark, France, Ireland, and the Netherlands similarly exceeded two times their GDP. At the end of 2008, we identified 30 publicly-listed banks worldwide with liabilities exceeding half of their country's GDP. Twelve of these had total liabilities exceeding 1 trillion US dollars.
These huge banks have assets well over $100 billion, far exceeding the technologically optimal size of around $25 billion found by Berger et al. (1997) on the basis of US data. Huge banks are no doubt difficult to manage effectively, and huge size may yield few additional risk diversification benefits. Banks may have grown this large in part because bank managers see their stature and pay increase with bank size. Alternatively, bank growth has been motivated by a desire to reach too-big-to-fail status, implying lower funding cost. Banks perhaps can increase their implicit claim on the financial safety net by ever increasing their size under normal business cycle conditions and in the absence of a major financial crisis. The financial and economic crisis that started in 2008, however, has been unexpectedly deep with a severe deterioration of the public finances so far and projected in the years to come. This raises doubts about countries' ability and determination to save their largest banks. At the very least, financially strapped governments may be forced to resolve any future large-bank failures in a relatively cheap way, implying large losses to bank creditors.
This paper investigates the impact of a country's public finances, in the form of government debt and deficits, on expected returns to bank shareholders as discounted in bank stock prices, making a distinction between systemically important and smaller banks. In a parallel fashion, we also consider the impact of government finances on expected losses on banks' liabilities, as reflected in the 5-year credit default swap (CDS) spreads. Specifically, we consider bank valuation over the 1991-2008 period, with 717 publicly-listed banks in 34 countries in 2008, and CDS spreads over the 2001-2008 period, with 59 banks in 20 countries in 2008.
Our results on the implications of bank size and government finances for bank stock valuation are as follows. A bank's market-to-book ratio is found to be positively related to the absolute size of its assets, while there is some evidence of a negative relationship between the market-to-book ratio and a bank's total liabilities-to-GDP ratio, as an indicator of systemic importance. For the overall sample, we further find that the bank market-to-book ratio is negatively related to government debt and deficits. The negative capitalization of government debt and deficits into bank share prices suggests that the expected consequences of higher public debts, which could be due to a combination of higher future taxation and lower future banking subsidies through the financial safety net, negatively affect returns to shareholders.
For our overall sample, we fail to find that bank valuation of systemically important banks is relatively sensitive to a country's public finances. At a time of financial crisis in 2008, however, we find that bank valuation of systemically large banks responds more negatively to a deterioration of the public deficit. This indicates that during a crisis distressed public finances reduce bank valuation through a less generous financial safety net, rather than just through the prospect of higher future bank taxation. In particular, subsidies through the financial safety net to systemically large banks appear to be reduced relatively more by weak public finances. This indicates that at a time of crisis systemically large banks are too big to save.
Government finance variables do not materially affect bank CDS spreads over the 2001-2008 sample period. However, we find that the increase in bank CDS spreads between 2007 and 2008 is significantly related to the deterioration of the public deficit, as evidence that expected credit losses on bank liabilities reflect the public finances during a severe financial crisis. Moreover, we find that CDS spreads are positively related to the fiscal cost relative to GDP of resolving any previous banking crisis. Thus, investors in bank liabilities appear to expect larger losses in countries that experienced costly banking crises before.
We also consider the pricing of bank risk, as measured by the volatility of weekly bank stock returns, into bank stock prices and CDS spreads, separately for systemically large and small banks. We find that the share prices of systemically large banks are more positively related to bank risk, while CDS spreads of systemically large banks are more negatively related to bank risk. This suggests that a marginal increase in bank risk increases the implicit subsidy from the financial safety net relatively more for systemically large banks – after controlling for systemic size and government finances. These results are in line with the view that systemically large banks are too large to fail.
Overall, we find that a systemically large bank may benefit relatively more from taking on more risk, while it can also lose relatively more from being in a country that runs large government deficits at a time of financial crisis. This makes the net benefit of systemic size ambiguous. It also suggests that some banks – particularly those with limited risk and located in high-deficit countries – may have grown beyond the size that maximizes their implicit subsidy from the financial safety net. Such banks can increase shareholder value by downsizing or splitting up. For our overall sample, estimated coefficients imply that the share prices of the average systemically important bank are discounted 22.3 percent on account of systemic size, providing strong incentives to reduce bank size relative to the national economy. Our data indicate that a smaller proportion of banks are systemically important - relative to GDP - in 2008 than in the two previous years, which could reflect private incentives to downsize.
This paper is related to several others that have considered the impact of bank size on bank stock returns and bank liabilities. In 1984, the US Comptroller of the Currency in testimony before Congress argued that a group of 11 large banks were 'too big to fail' (TBTF) and that for those banks total deposit insurance would be provided. Using an event study methodology for a sample 63 US banks, O'Hara and Shaw (1990) find that there are positive wealth effects accruing to these TBTF banks, while there are negative wealth effects accruing to the smaller banks.
The positive wealth effect of TBTF suggests that a bank merger that creates a bank that is TBTF can create wealth for bank shareholders. Considering US bank mergers over the 19911998 period, Kane (2000) finds that stockholders of large-bank acquirers have gained value when a deposit institution target is large and even more value when a deposit institution target was previously headquartered in the same state. Benston, Hunter and Wall (1995) similarly find that bank mergers and acquisitions are in part motivated by enhancing the deposit insurance put option.
Moreover, the benefits of gaining TBTF status following bank mergers are not limited to stockholders. Penas and Unal (2004) consider the returns to bond holders around US bank mergers in the 1991-1997 period. These authors find that adjusted returns of merging banks' bonds are positive across pre-merger and announcement months. These positive returns are attributed to gaining TBTF status, in addition to diversification gains and, to a lesser extent, synergy gains.
All of these papers have aimed to identify an impact of TBTF by considering the differential pricing of bank stock and liabilities for large and small banks. Alternatively, an impact of TBTF on bank liability pricing can be ascertained by comparing the pricing of bank liabilities over different periods, during which TBTF is supposed to hold to different extents. In this vein, Flannery and Sorescu (1996) consider the determination of spreads on bank subordinated debentures over different subperiods during the years 1983-1991. These spreads should reflect bank-specific risk indicators less during times of greater likelihood of application of TBTF policies. Flannery and Sorescu (1996) specifically find that spreads reflect bank risk indicators relatively less during the last three years of the 1983-1991 period, since after 1998 many bank and thrift debenture holders had suffered losses during bank failures signaling a lowered adherence to TBTF.
Similarly, Sironi (2003) considers the sensitivity of spreads of European banks' subordinated notes and debentures during the 19991-2001 period and finds that these spreads are relatively insensitive to bank risk in the second part of the 1990s, consistent with a disappearing perception of TBTF type guarantees on the part of investors. Sironi (2003) attributes the apparent diminution of TBTF in Europe during the 1990s to the joint effect of the loss of monetary policy by national central banks and the public budget constraints imposed by the European Monetary Union.
The TBTF literature essentially investigates the authorities' need or desire to provide more support for relatively large banks on the assumption that governments are able to do so. Brown and Dinç (2009) is the first paper to provide evidence that a country's ability to support its financial sector, as reflected in its public deficit, affects its treatment of distressed banks. These authors consider government takeover or closure decisions of banks in 21 emerging market economies during the 1990s. As expected, a bank is more likely to be taken over or closed by the government, if its own capital ratio is low. However, is it less likely to be taken over, if the average capital ratio of other banks in the same country is low as well. This is taken to be evidence of ‘too many to fail,' as the state may be unable to close many weak banks simultaneously. Interestingly, the ‘too many to fail' effect is relatively weak in countries with high public budget balances. While Brown and Dinç (2009) find that countries with weak public finances are slow to close weak banks, it does not follow that banks in fact benefit from being in countries with weak public finances, since the counties may in the end be forced to adopt cheap resolution methods, implying large losses to bank creditors.
Differentiating between systemically important and other banks, we consider the impact of the public finances on bank stock prices and CDS spreads, reflecting the net effect of potentially different timing and resolution method decisions. Our results indicate a negative effect of higher debt or deficits on bank stock prices, for the first time documenting how the state of public finances may limit net subsidies to the banking sector. This ‘too large to save' effect is consistent with the observed downsizing of banks that has been occurring in recent years.
The remainder of this paper is organized as follows. Section 2 discusses the data. Section 3 outlines the empirical strategy and presents the results. Section 4 concludes.