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| Type | Master's Thesis |
| Scope | Discipline-based scholarship |
| Title | Debt Funding Costs of Large European Banks in Anticipation of Government Bailouts |
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| Language |
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| Institution | University of Zurich |
| Faculty | Faculty of Economics, Business Administration and Information Technology |
| Number of Pages | 26 |
| Date | 2015 |
| Abstract Text | Executive Summary I. Problem Too big to fail (TBTF) is a market notion that the government would intervene to pre-vent the failure of a large, interconnected and complex financial institution to avoid de-stabilizing the financial sector and limit the adverse effects on the economy as a whole. The perception that a government would rescue a large bank in distress can lead to dis-torted incentives among market participants to properly price the risks of banks viewed as TBTF, potentially leading to funding and other advantages. II. Objective The aim of this paper is to review whether the largest European banks have benefitted, and possibly still are benefitting from perceived government support. To answer this question, this paper focuses on the evolution of debt funding costs of these banks and does not take into account other benefits that may arise due to the perception of gov-ernment rescues. The scope and methodology of the empirical approach used in this paper are based on a previous study published in 2014 by the United States Government Accountability Office (the “GAO study”). The GAO study analysed debt funding costs of US bank holding companies for the years 2006-2013 and found that the largest finan-cial institutions had lower funding costs during the 2007-2009 financial crisis but that the difference between the funding costs of the largest and smaller institutions has since declined. This study replicates the empirical methodology used in the GAO study for European banks. The objective is to eventually answer the question how the perception of TBTF has evolved in Europe in contrast to the US in recent years. III. Approach To assess whether large European banks have a funding cost advantage over smaller banks, an econometric analysis of the relationship between a bank’s size and its funding costs has been conducted. For this purpose this study used a multivariate regression model to estimate this relationship, while controlling for factors other than size that may also influence funding costs. Several measures were constructed to control for size, credit risk and other bank and bond characteristics due to uncertainty about how to cap-ture these important factors affecting bond yields and because the regression results may be sensitive to alternative specifications. Altogether, 25 separate models were used for each year from 2006 – 2013. IV. Results The empirical analysis provides mixed evidence for the years 2006-2010 but strong evi-dence suggesting that larger banks had a funding cost advantage over their smaller competitors in 2012 and 2013. The predicted advantage for banks with 1 trillion EUR in total assets compared to banks with 10 billion EUR in total assets ranges from 21bp to 95bp, dependent upon the model used. For the year 2009 the model predictions are only significant for one model specification and suggest an advantage for large banks of 30bp, for the same comparison in total assets as mentioned above. To assess whether changes in funding cost differences might be associated to changes in the level of credit risk of large banks, a hypothetical prediction was made, using average credit risk levels of 2009 for all years. The estimation show that the predicted bond funding cost ad-vantage of large banks did not change significantly in this scenario. This suggests that the change in the level of credit risk over the years has had a small effect on the evolu-tion of funding cost differences between larger and smaller banks. This stands in con-trast to the findings of the study conducted by the GAO in 2014. While their findings suggest that the perception of government support has changed among investors over the years, reflected in the diminishing funding cost advantages of larger banks, this study could not find any statistical evidence of such a trend for European banks. As the regulatory approaches in the US have been tackling the too big to fail issue sooner, and with more stringent new provisions, the differing results between this study and the study conducted by the GAO might be affiliated to these regulatory differences. V. Conclusion Although the empirical results provide evidence that larger European banks still have a funding cost advantages over smaller competitors, these results need to be interpreted cautiously. First, there might be several other factors not included in this study that may have an effect on funding cost, leading to potential biases among the estimators includ-ed in this study. Second, this study included banks with different countries of domicile, for which country-specific factors might exist and potentially impact the funding costs of banks in that country. The possibility of country-specific factors could not be consid-ered in the empirical analysis, as this would pose difficulties on how to integrate these effects into the regression model. Third, and most relevant in the eyes of the author, this study as well as the GAO study did not take into account that size-related funding ad-vantages may as well be observed in other industries. Therefore, attributing the total funding cost advantage found in this study to the TBTF dilemma might result in an overestimation of the TBTF effect on funding costs. |
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