Does banks’ size distort market prices?Evidence for too-big-to-fail in the CDS market

This paper examines the potential distortion of prices in the CDS marketcaused by too-big-to-fail. Overall, we find evidence for market discipline inthe CDS market. However, CDS prices are distorted due to a size effect whicharises when investors expect a public bail-out as a result of too-big-to-fail. Aone percentage point increase in size reduces the CDS spread of a bank byabout two basis points. We further find that some banks have already reacheda size that makes them too-big-to-be-rescued. While the price distortion forthese banks decreases the existence of banks that are considered to be toobig-to-rescue raises important new issues for banking supervisors.[...] Manja Völz, Michael Wedow