Putting Out the Government Put

The impact of public guarantees on bank risk taking.

January 13, 2011

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984948_money_isolated_with_backdropFinancial innovation, as Ed Kane said at the recent CIR Investment Investment Conference, is not always a good thing. Who ultimately foots the bill when the risks dissolve the rewards and become a flood that threatens to engulf the financial system?

He’s not alone on that thought. Over at The Baseline Scenario, former IMF economist Simon Johnson, looks out on the new financial landscape. Same as it ever was, except more concentrated. Fannie Mae, Freddie Mac, fuhgeddaboutit.

“Today’s most dangerous government sponsored enterprises are the largest six bank holding companies: JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley. They are undoubtedly too big to fail – if they were on the brink of failure, they would be rescued by the government, in the sense that their creditors would be protected 100 percent. The market knows this and, as a result, these large institutions can borrow more cheaply than their smaller competitors. This lets them stay big and – amazingly – get bigger.

“In the latest available data (Q3 of 2010), the big 6 had assets worth 64 percent of GDP. This is up from before the crisis – assets in the big six at the end of 2006 were only about 55 percent of GDP. And this is up massively from 1995, when these same banks (some of which had different names back then) were only 17 percent of GDP.

“No one can show significant social benefits from the increase in bank size, leverage, and overall riskiness over the past 15 years. The social costs of these banks – and their complete capture of the regulatory apparatus – are apparent in the worst recession and slowest recovery since the 1930s.”

But what if the banks were put on iron rations and had to make forced marches through the turmoil. Over at the European Central Bank, some researchers have found a positive impact in the reduction of flab to prudence ratio. In “The Impact of Public Guarantees on Bank Risk Taking,” Reint Gropp, Christian Gruendl and Andre Guettler examine a fortuituous test case: when Germany stopped guarantees for depositors against bank defaults.

“In 2001, government guarantees for savings banks in Germany were removed following a law suit. We use this natural experiment to examine the effect of government guarantees on bank risk taking, using a large data set of matched bank/borrower information. The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. At the same time, the banks also increased interest rates on their remaining borrowers. The effects are economically large: the Z-Score of average borrowers increased by 7.5% and the average loan size declined by 17.2%. Remaining borrowers paid 46 basis points higher interest rates, despite their higher quality. Using a difference-in-differences approach we show that the effect is larger for banks that ex ante benefited more from the guarantee and that none of these effects are present in a control group of German banks to whom the guarantee was not applicable. Furthermore, savings banks adjusted their liabilities away from risk-sensitive debt instruments after the removal of the guarantee, while we do not observe this for the control group. We also document in an event study that yield spreads of savings banks’ bonds increased significantly right after the announcement of the decision to remove guarantees, while the yield spread of a sample of bonds issued by the control group remained unchanged. The results suggest that public guarantees may be associated with substantial moral hazard effects.”

An interesting bit of research. But it may have been repudiated by history, since a number of German Landesbanks were brought low by the financial crisis – and Germany is still on the hook for the Greek, Irish, Portuguese … and potential Spanish bailouts. Contagious enthusiasm for risk, followed by solitary hangovers for improvidence, one might say, whatever the government guarantees.

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