The Impact of Public Guarantees on Bank Risk-Taking: Evidence from a Natural Experiment
Review of Finance, Volume 18, Issue 2, 1 April 2014, Pages 457–488,https://doi.org/10.1093/rof/rft014
Public guarantees in the wake of the financial crisis of 2007/2008 have been wide-spread. Many countries either nationalized banks, provided blanked guarantees for the banking system or both.
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.
We use data provided by the German Savings Banks Association for the years 1996 to 2006, which symmetrically spans the removal of government guarantees in 2001. It provides annual financial statements for 452 savings banks. The control group includes financial statements for all non-savings banks available for Germany in Bankscope, comprising bank holding companies, commercial banks, cooperative banks, and medium and long term credit banks. The control sample consists of 877 banks.
Our results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. Using a difference-in-differences approach we show 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 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.
Overall, the evidence implies that public guarantees may be associated with substantial moral hazard effects.