Safer Ratios, Riskier Portfolios: Banks’ Response to Government Aid

Abstract

We study the effect of government assistance on bank risk taking. Using hand-collected data on bank applications for government assistance under the Troubled Asset Relief Program (TARP), we investigate the effect of both application approvals and denials. To distinguish banks' risk taking behavior from changes in economic conditions, we control for the volume and quality of credit demand based on micro-level data on home mortgages and corporate loans. Our difference-indifference analysis indicates that banks make riskier loans and shift investment portfolios toward riskier securities after being approved for government assistance. However, this shift in risk occurs mostly within the same asset class and, therefore, remains undetected by the closely-monitored capitalization levels, which indicate an improved capital position at approved banks. Consequently, these banks appear safer according to regulatory ratios, but show a significant increase in volatility and default risk.

Competition and bank stability

“…Studies, analyzing how distortions to bank competition due to government support affects risk also yield mixed results. Duchin and Sosyura (2014) find that a bail-out of U.S. banks during the recent financial crisis increases risk taking, while Gropp et al (2013) find that a removal of implicit government guarantees reduces risk taking for German banks.…”

Wishful thinking or effective threat? Tightening bank resolution regimes and bank risk-taking

“…Bagehot (1873) already noted the moral hazard e ect and excessive risk-taking induced by banks' expectation for bailout (instead of resolution). Although various rationales for bailout policies can be formulated (Acharya and Yorulmazer, 2007;Diamond and Dybvig, 1983;Diamond and Rajan, 2005), several recent studies provide empirical evidence regarding the moral hazard e ect of bailout (expectations) on risk-taking (e.g., Black and Hazelwood, 2013;Dam and Koetter, 2012;Duchin and Sosyura, 2013). Conversely, when bailout guarantees cease to be implicit through a credible and enforceable improvement in bank resolution regimes, we expect banks to change their behavior towards less risk-taking.…”

“…Our paper contributes to the recent literature on the e ects of regulatory actions on bank behavior, particularly risk-taking (e.g., Berger et al, 2012;Black and Hazelwood, 2013;Dam and Koetter, 2012;Duchin and Sosyura, 2013). Whereas these papers focus primarily on the e ects of government bailout policies, we investigate the e ects of an ex ante disciplining regulatory approach.…”

“…6 Black and Hazelwood (2013)and Duchin and Sosyura (2013) provide evidence that (at least large) TARP-funded U.S. banks increased risk-taking after the capital injection. Dam and Koetter (2012) exploit a dataset on capital injections in Germany and nd that bailout expectations (through observed capital injections) increase risk-taking in the entire banking sector (measured as the probability of default).…”

“…As outlined above, we de ne and compute several indicators for bank business model and investment choices that have been suggested in the previous literature (Brunnermeier et al, 2012;DeJonghe, 2010;DeYoung, 2013;Duchin and Sosyura, 2013). We test the di erence-in-di erence e ect by using these indicators as dependent variables in our multivariate baseline model, including xed e ects and additional controls.…”