Does Banks' Size Distort Market Prices? Evidence for Too-Big-To-Fail in the CDS Market

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Abstract
This paper examines the potential distortion of prices in the CDS market caused by too-big-to-fail. Overall, we find evidence for market discipline in the CDS market. However, CDS prices are distorted due to a size effect which arises when investors expect a public bail-out as a result of too-big-to-fail. A one percentage point increase in size reduces the CDS spread of a bank by about two basis points. We further find that some banks have already reached a size that makes them too-big-to-be-rescued. While the price distortion for these banks decreases the existence of banks that are considered to be too-big-to-rescue raises important new issues for banking supervisors.