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

Abstract

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.