Depositor Discipline During Good and Bad Times: The Role of the Guarantor of Last Resort

Abstract

In this paper, we investigate, for the first time in the literature, whether the ability of the public sector or government (GLR), to effectively help banks or guarantee bank liabilities affects the sensitivity of interest costs and deposit dynamics to banks’ fundamentals. To test our hypothesis, we gathered a global bank sample covering the period from 1991 to 2012. We proxy for the GLR’s risk using sovereign ratings, credit default swap spreads, bond yields and changes in macroeconomic indicators. Additionally, we observe the period subsequent to systemic financial crises. Regardless of the method we apply to describe the GLR’s risk and the estimation procedure employed, we find that interest cost sensitivity to banks’ fundamentals, especially equity capital, is generally an increasing function of the GLR’s risk. Moreover, we provide evidence that the relationship between interest cost sensitivity to banks’ fundamentals and the GLR’s risk is non-linear and is even U-shaped in certain cases. Therefore, in economic terms, our results indicate that, paradoxically, moderate GLR risk levels may foster market monitoring by depositors.