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What Can Volatility Smiles Tell Us About the Too Big to Fail Problem?

Published online by Cambridge University Press:  20 February 2023

Phong T. H. Ngo Open the ORCID record for Phong T. H. Ngo [Opens in a new window]  and
Diego L. Puente-Moncayo
Phong T. H. Ngo*
Affiliation:
The Australian National University Research School of Finance, Actuarial Studies and Statistics
Diego L. Puente-Moncayo
Affiliation:
The Australian National University Research School of Finance, Actuarial Studies and Statistics diego.puente@anu.edu.au
*
phong.ngo@anu.edu.au (corresponding author)
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Abstract

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We exploit the information content of option prices to construct a novel measure of bank tail risk. We document a persistent increase in tail risk for the U.S. banking industry following the global financial crisis, except for banks designated as systemically important by the Dodd–Frank Act. We show that this post-crisis difference in tail risk for large and small banks is consistent with the too-big-to-fail (TBTF) status of large banks being reinforced by the Dodd–Frank designation: Naming the banks whose failure could threaten the financial stability of the U.S. gave investors a list of banks the government deemed as TBTF.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 2 , March 2024 , pp. 863 - 895
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Thierry Foucault (the editor) and David Schreindorfer (the referee) for helpful comments that substantially improved the article. We also thank Mark Flannery, Iftekhar Hasan, Jean Helwege, Kose John, Jonathan Smith, Patricio Valenzuela, Eliza Wu, and seminar participants at the 2019 International Finance and Banking Society, the Conference on Financial Stability and Sustainability 2020, the Australian National University, the University of Technology Sydney, and the University of Sydney for helpful comments and discussions.

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