Effect of too-big-to-fail subsidies on bank borrowing costs: Australian evidence

The recent global financial crisis raises the concern that large banks are too big to be allowed to fail, thereby distorting risk taking incentives, market discipline of banks' business activities and competitive dynamics. With the highly interconnected and concentrated nature of the Australian banking sector, an ideal natural experimental environment is available to examine the too-big-to-fail subsidies in a small open economy that is heavily reliant on banks for funding economic growth. By analysing primary bond market data from 2004 to 2015, this research suggests large banks realise a funding advantage in the form of implicit government guarantees after including different control variables in the analysis. In addition, bond investors are found to be less sensitive to large banks' risk, which is consistent with perceptions of possible government support in the event that the bank becomes financially distressed. Further, this study provides an early indication of whether the Base III capital framework is effective in mitigating too-big-to-fail effects. I find evidence that the funding advantage of large banks is reduced since Base III implementation. This result will be of interest to jurisdictions implementing the new capital framework in subsequent years.