Turns Out &#39;Bailout Funds&#39; Really Do Increase Risk Taking

christopherdodd tbi

Economists from London's EBS released a paper that will be very unpopular with Senate Democrats.

Reint Gropp and others considered whether government guarantees cause banks to take on more risks -- which is the standard argument against Dodd's bill. Or whether higher charter values decrease the incentives for risk taking, because the threat of losing future rents will act as a deterrent.

Turns out the Republicans were right. There was a decrease in risk-taking when guarantees were removed at German banks in 2001 (From VOX.eu):

The removal of government guarantees not only significantly decreased the risk taking of banks (the Z-Score of average borrowers increased by 7%), but we also show that after the removal of guarantees, banks reduced average loan size (by 13%) and overall lending volumes (by 22%). Riskier borrowers were either denied credit or were given a smaller loan. At the same time, banks increased interest rates for loans on the remaining borrowers (plus 57 basis points), despite their higher quality.

We find that these effects tend to be significantly larger for banks, where it is likely that the ex ante value of guarantees was higher. First, the effects are larger for savings banks which were more risky before the removal of state guarantees. Ex ante riskier banks appear to have reduced their risk taking more after the removal of guarantees relative to ex ante safer banks. Second, savings banks which were associated with a more risky federal state bank also reacted more strongly to the removal of public guarantees. Our results show that the reduction in risk, the reduction in loan size, and the increase in interest rate spread were all significantly larger for savings banks that were associated with a riskier federal state bank.

Finally, we show that the savings banks adjusted their risk taking both by dropping existing risky borrowers from their loan books (monitoring) and by tightening their lending standards for new borrowers (screening). The results suggest that some borrowers – generally the riskiest ones – lost access to credit due to the removal of guarantees

The paper could be the final nail in the coffin for Dodd's bailout fund, which even Obama doesn't like. But then we're back to the problem of implicit bailouts.

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