Research: Banks Assume More Risk if Bailed Out

Econintersect:  A research paper from the University of Michigan (by Ran Duchin and Denis Sosyura) has found that that after the bailout, bailed banks approved riskier loans and shifted investment portfolios toward riskier securities.  Because of the way these greater risks were assumed, these banks actually appear to be safer based on capitalization requirements, compared to banks that did not get any government assistance during the financial crisis.  The same results were found in all three areas examined:  retail lending (mortgages), corporate lending (large syndicated loans), and investment in financial assets.  Click on cartoon for larger image.

The differences between bailed and not bailed banks was dramatic.  From a summary in Strategy + Business:

After controlling for bank fundamentals and changes in security valuations, the authors found that non-recipients were much less likely to make risky investments. Because high-yield bonds have lower credit ratings and are widely regarded as more likely to default, the researchers used asset yield as a market measure of risk. For bailed-out banks, the average interest yield on investment portfolios shot up by 9.4 percent after getting government aid compared with banks that received no federal funds.

And there is a real economic consequence for bailed-out banks, say the authors, who measured the level of systemic risk through an analysis of firms’ earnings volatility, leverage, stock return volatility, and market beta — a measure of the risk contained in a security or portfolio vis-à-vis the overall market. Compared with applicants that did not receive federal funds, recipient firms increased their exposure to systemic risk after getting government money, the authors found, with their beta measure increasing substantially, from 0.8 to 1.01. In contrast, non-participating banks experienced no changes in systemic risk over the same period.

Overall, the authors write, their analysis “indicates a robust increase in risk taking in both lending and investment activities by bailed financial institutions, as compared to fundamentally similar banks, which were denied federal assistance.”

Is this another case study in moral hazard?

Sources:  Social Science research Network and Strategy + Business

Hat tip to Roger Erickson