Funding advantage and market discipline in the Canadian banking sector

2025-07-16

AI Summary

This study investigates whether Canadian large banks possess systemic funding advantages over small banks and how market discipline varies across debt instruments—deposits, senior debt, and subordinated debt. Using hand-collected, comprehensive bank debt issuance data, we estimate econometric models controlling for bank-specific characteristics and systemic risk exposure, complemented by multidimensional statistical and comparative analyses. We find that, even in the absence of explicit government bailouts, large banks benefit from implicit government guarantees: their deposit and subordinated debt funding costs are 80 and 70 basis points lower, respectively. Market discipline is robust only for subordinated debt, while virtually absent for deposits and senior debt. These results provide the first systematic identification of a “debt-tier–dependent market discipline” mechanism in the Canadian banking system. The findings offer critical empirical support for tiered regulatory frameworks—including Total Loss-Absorbing Capacity (TLAC) requirements and reforms to debt priority structures—to enhance financial stability.

Technology Category

• Game Theory and Economic Paradigms: Auctions and Market-Based Systems
• Multiagent Systems: Mechanism Design
• Machine Learning: Other Foundations of Machine Learning

Application Category

• Security and Privacy: Large-scale security measurements
• Economics, Online Markets and Human Computation: Incentives in network design for Web infrastructures and ecosystems
• Social Networks and Social Media: Generative AI / large language models and their impact on social systems

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.

Problem

• Measure large banks' funding advantage in Canada
• Assess market discipline across Canadian bank securities
• Examine impact of implicit government guarantees on banks

Innovation

• Comprehensive data set and diverse methods
• Analyzes funding advantage and market discipline
• Hand-collected market data on debt issues