Merge to be too big to fail: A real option approach

We develop a real option model to analyze the timing of bank mergers motivated by the incentive to obtain too-big-to-fail (TBTF) status from the government. We show that mergers may occur even in the absence of scale economies, which is different from Lambrecht (2004). Moreover, the TBTF incentive lowers the threshold required for bank mergers, and the degree of scale diseconomies that the merging entities can tolerate increases as the probability of obtaining the TBTF status becomes higher. Our findings thus provide a theoretical explanation for the lack of scale economies in bank mergers identified in prior literature.