Bank mergers and too-big-to-fail policy

It is widely believed that in most countries governments adhere to a too-big-to-fail (TBTF) policy of protecting uninsured debtholders of large insolvent banks whose failure could trigger a contagion process through the financial system.;In the first chapter we set up a model to analyze the banks' risk and funding decisions (between insured and uninsured funds), in a regulatory framework that includes both deposit insurance and bailout policy. The model predicts that, contrary to conventional wisdom, it is possible for risk to decrease (increase) after an increase (decrease) in the probability of bailout. This is due to the fact that the bank reacts to the reduction (increase) in the cost of uninsured funds to raise a significantly higher (lower) proportion of uninsured debt, making the liability mix more (less) sensitive to risk. This may lead to an optimal decision to reduce (increase) risk. This negative relationship between risk and probability of bailout is more likely the more elastic the supply of insured funds. Second, the model shows that an increase in risk is a necessary condition for the proportion of insured deposits to increase, suggesting the use of this ratio as a warning signal.;In the second and third chapters we provide empirical evidence that supports the hypothesis that an important motivation for bank mergers is to become too big to fail. We show that merging banks' bond adjusted returns are positive and significant in premerger and announcement months. Also, the acquiring banks' credit spreads on new debt issues are lower after the merger. The cross-sectional regression results provide evidence that the incremental size attained in the merger is a significant determinant of both the positive bond returns as well as the decline in credit spreads after controlling for factors such as diversification, leverage and asset quality changes. Moreover bond returns around the merger announcement and the postmerger decline in spreads are not monotonic with size. These effects are only significant for medium-size banks, which constitute the group that is most likely to acquire TBTF status after the merger.