Funding advantage and market discipline in the Canadian banking sector

TL;DR

This study investigates the funding advantage of large Canadian banks and the presence of market discipline, revealing that large banks benefit from lower funding costs and market discipline is evident in subordinated debt but not in senior debt.

Contribution

It provides empirical evidence on the magnitude of large banks' funding advantage and the extent of market discipline in the Canadian banking sector, considering the unique context of no government bailouts.

Findings

Large banks pay 70-80 basis points less on deposits and subordinated debt.

Market discipline exists for subordinated debt but not for senior debt.

Canadian banks' funding advantage is significant after controlling for risk factors.

Abstract

We employ a comprehensive data set and a variety of methods to provide evidence on the magnitude of large banks' funding advantage in Canada in addition to the extent to which market discipline exists across different securities issued by the Canadian banks. The banking sector in Canada provides a unique setting in which to examine market discipline along with the prospects of proposed reforms because Canada has no history of government bailouts, and an implicit government guarantee has been in effect consistently since the 1920s. We find that large banks have a funding advantage over small banks after controlling for bank-specific and market risk factors. Large banks on average pay 80 basis points and 70 basis points less, respectively, on their deposits and subordinated debt. Working with hand-collected market data on debt issues by large banks, we also find that market discipline exists for subordinated debt and not for senior debt.