Are banks too big to fail or too big to save? International evidence from equity prices and CDS spreads

Deteriorating public finances around the world raise doubts about countries’ abilities to bail out their largest banks. For an international sample of banks, this paper investigates the impact of government indebtedness and deficits on bank stock prices and CDS spreads. Overall, bank stock prices reflect a negative capitalization of government debt and they respond negatively to deficits. We present evidence that in 2008 systemically large banks saw a reduction in their market valuation in countries running large fiscal deficits. Furthermore, the change in bank CDS spreads in 2008 relative to 2007 reflects countries’ deterioration of public deficits. Our results suggest that some systemically important banks can increase their value by downsizing or splitting up, as they have become too big to save, potentially reversing the trend to ever larger banks. We also document that a smaller proportion of banks are systemically important - relative to GDP - in 2008 than in the two previous years, which could reflect these private incentives to downsize.