Did the Bailout Encourage Risk-Taking?

The following post comes to us from Ran Duchin and Denis Sosyura, both of the Department of Finance at the University of Michigan.

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.

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  1. Wayne Isaacks
    Posted Tuesday, October 25, 2011 at 10:57 am | Permalink

    Of course the regulationa and bailouts increase risk-taking by banks, if one could take more risk. After all, the banks have no capital at risk, bankers have no downside carreer risk. Go for the long shot, and short-term profit measured by manipulated short-term “cash in sight” calculus, and distribute the “profits” (cash) that is essentially borrowed, and bet.

    OK, this is not rocket science, or Wharton School of finance stuff. It is mom’s home budget and dad’s a drunk who gables all the time simple.

    If you want sound banks, require real capital, and put the frauds in jail.

    Yes, we will have less robust, less frothy booms.

  2. fx
    Posted Monday, November 28, 2011 at 8:08 pm | Permalink

    Isn’t it getting a case of trying to embrace capitalism while leaning towards socialism or reverse socialism?

    Theoretical views of different economic theories are one thing. On one side we can say that it would increase the probability of high risk taking, on other side we can argue that it will prevent the banks from high risk taking behavior because increased charter values and hence more at stake and we can also say that it would not change much as far as risk taking behavior is concerned.

    One of the studies by Benston and Kaufman (1995) about the reasons behind bank failures summarizes the reasons as follows:

    1) Excessive expansion of bank credit or the excessive risk taking (of course before the crisis)
    2) Asymmetric information resulting in the inability of depositors to value bank assets accurately.
    3) Shocks originating outside of the banking system, independent of the financial conditions of banks that either cause depositors to change their liquidity preference or cause reduction in bank reserves.
    4) Institutional and legal restrictions that weaken banks, making them unnecessarily prone to failure.

    The excessive risk taking comes as point number 1. Not only that but the point number 2 is also indirectly related to the risk assessment. So the behavior of banks can be considered something which in not to bank upon and considering this I would, theoretically, say that the bailed out bank will continue to think like that if there is no major change of the management. Regulations and physical boundaries can work only to a limit but cannot change the core. With bailing out it will be more like trying to get out of the hole as fast as possible.

    But then theories are theories and hence I really admired the efforts made on the practical research and findings. Kudos…