Did the Bailout Encourage Risk-Taking?

In the paper, Safer Ratios, Riskier Portfolios: Banks’ Response to Government Aid, which was recently made publicly available on SSRN, we investigate the effect of TARP on bank risk taking. One of the key features of the past decade has been an increased role of government regulation, which culminated in the bailout of over 700 firms under the Emergency Economic Stabilization Act (EESA) of 2008. At the forefront of an ongoing regulatory debate is the potential effect of the bailout on the risk-taking behavior of financial institutions, since imprudent risk-taking is often blamed for leading to the crisis in the first place. On the one hand, recent regulatory reforms, including the EESA, the Dodd-Frank Act of 2010, and Basel III, were tasked with promoting financial stability and preventing excessive risk-taking by financial institutions. On the other hand, the bailout sent a signal of implicit protection of certain financial institutions, which could encourage risk-taking as a response to a perceived safety net for institutions that encounter financial distress.

We study three channels of bank operations – retail lending, corporate lending, and financial investments. We use hand-collected data on bank applications for government capital to control for the selection of fund recipients and investigate the effect of both application approvals and denials. To distinguish banks’ risk taking behavior from changes in economic conditions, we also control for the volume and quality of credit demand based on micro-level data on home mortgages and corporate loans.

In difference-in-difference analysis, we find that after the bailout, bailed banks increase risk-taking across all three channels. In particular, after receiving government assistance, bailed banks approve riskier loans and shift investment portfolios toward riskier securities. For example, after TARP, bailed banks increased their portfolio allocations to riskier securities by 6.2%, as compared to non-bailed banks with similar characteristics. Further, the average interest yield on investment portfolios of TARP banks increased by 9.4% relative to unapproved TARP applicants.

However, this shift in risk occurs mostly within the same asset class and, therefore, has little effect on the closely-monitored capitalization levels. Consequently, bailed banks appear safer according to the capitalization requirements, but show a significant increase in overall risk. We estimate that the risk of default of bailed banks increased by 24% after TARP relative to non-bailed banks. Furthermore, in contrast to one of the main objectives of EESA, bailed banks show no significant increase in their lending, as compared to non-bailed banks with similar characteristics.

The full paper is available for download here.