The effect of TARP on bank risk-taking
Highlights
► Analysis on the risk of loan originations by banks that received funds under TARP. ► Large TARP recipients increased loan risk relative to non-TARP peers. ► Small TARP recipients decreased loan risk relative to non-TARP peers. ► Increase in risk at large TARP banks without increased lending is suggestive of moral hazard.
Introduction
The Troubled Asset Relief Program (TARP), a program of the US Treasury to purchase equity in financial institutions and recapitalize the financial sector, was one of the largest measures implemented by the US government in 2008 to address the financial crisis. The provision for TARP by Congress allowed the Treasury to purchase or insure up to $700 Billion of troubled assets or to purchase equity in the banks themselves. On October 28, 2008, Treasury Secretary Henry Paulson authorized the first wave of TARP equity capital injections for nine of the largest US financial institutions.2 Shortly thereafter, more banks received funds from the government under the TARP program.
The original focus of TARP appears to have been stabilization of the banking sector. In this respect, TARP was designed to improve the safety and soundness of the banking system through increased capitalization. Hoshi and Kashyap (2010) describe how these efforts were similar to those used to stabilize Japanese banks in the 1990s. The Emergency Economic Stabilization Act (EESA) passed by Congress in 2008, which created TARP, also included specific provisions aimed at reducing the “excessive risk-taking” that was believed to have contributed to the financial crisis.
Public discourse subsequent to the program's implementation revealed that TARP was implicitly expected to increase bank lending. Shortly after the first round of injections in October 2008 under the Capital Purchase Program (CPP), Anthony Ryan, Acting Treasury Under Secretary for domestic finance, said in a speech: “As these banks and institutions are reinforced and supported with taxpayer funds, they must meet their responsibility to lend” (Ryan, 2008). Fig. 1 shows that total commercial and industrial loans in the US began to fall dramatically near the end of 2008, which is also the window of time in which the Treasury began making capital infusions into banks under the TARP program. The following year, a congressional oversight panel charged with evaluating the TARP program issued a report which criticized the US Treasury for having no ability to ensure that banks were lending the money that they received from the government (Congressional Oversight Panel, 2009).
To expand lending during an economic downturn would likely require banks to increase the riskiness of their lending. Government support of banks may facilitate the financing of beneficial projects that private banks would be unable or unwilling to finance otherwise (Stiglitz, 1993) and, as such, government-supported banks should mitigate the restriction of credit supply by increasing their lending during recessions. According to this theory, government support of banks can address market failures and improve social welfare. However, explicit government support also provides a perception of implicit government support going forward, which can induce excessive risk-taking. Although TARP did not create a new government safety net, it was a form of “bank bailout” which likely influenced perceptions about the likelihood of banks being bailed out in the event of future losses. This can incentivize banks to shift their lending toward higher-risk, higher-return projects. Therefore, increased risk-taking in the absence of increased lending may be the result of moral hazard.
The conflicted nature of the TARP objectives reflects the tension between different approaches to the financial crisis. While recapitalization was directed at returning banks to a position of financial stability, these banks were also expected to provide macro-stabilization by converting their new cash into risky loans. TARP was a use of public tax-payer funds and some public opinion argued that the funds should be used by banks to make loans, so that the benefit of the funds would be passed through directly to consumers and businesses. Similarly, during the 2007–2009 financial crisis, many European banks were bailed out by their national governments through a range of provisions that included equity capital injections.3 As in the US, this partial nationalization of large banking groups revived the debate concerning the benefits and costs of government support for banks.
Given the conflicted nature of these objectives, it is an open question as to how TARP might have affected risk-taking incentives relative to changes in bank lending. In this paper, we try to empirically identify the effect of TARP on bank risk-taking. One of the areas of activity in which the TARP capital infusions might have an effect on bank risk-taking is in commercial and industrial (C&I) lending. Using data from the Survey of Terms of Business Lending (STBL), we examine the lending patterns of both TARP and non-TARP recipients around the time of the TARP capital infusions. We use the STBL data because they contain risk rating information on a quarterly measure of loan originations for a broad sample of US banks of various sizes. By using the STBL we can analyze data on loan originations and risk before and after TARP infusions. Specifically, we identify how the risk ratings of commercial loan originations at TARP banks change relative to non-TARP banks in response to the TARP capital infusions.
In our analysis, we first use a difference-in-differences methodology to evaluate the effect of TARP on the average risk ratings of commercial loan originations. One challenge in taking this approach is that the type of commercial loan originations can differ significantly by bank size. To focus on the differences within peer groups, we stratify the sample by bank size and compare TARP and non-TARP recipients by size class. In the second part of our analysis, we use loan-level regressions to evaluate whether TARP banks changed the average riskiness of their loan originations after receiving TARP funds.
Our results indicate that TARP had a surprising effect on bank risk-taking. In our difference-in-differences analysis and in our regression results, we find evidence that the average risk of loan originations at large TARP banks increased relative to non-TARP banks through 2009 whereas the average risk at small TARP banks decreased relative to non-TARP banks. We also examine some aspects of this channel more closely. When splitting the sample by loan size, we find that the increased risk ratings for large TARP recipients was primarily through small loans. The results are also shown to be weaker when allowing for TARP repayment, which suggests that the effect of TARP continued even after government money was no longer funding the banks’ balance sheets.
Our results may reflect the conflicting influences of government support on bank behavior. Although TARP money was given to increase bank stability and reduce incentives to take excessive risks, it was also given with the understanding that the funds would be used to expand lending during a period of increased risk. These two objectives have an opposing influence on bank risk-taking that may have led to a different effect of TARP on lending by large and small banks. Having received this government support, large banks may also have been more susceptible to the moral hazard incentives for risk-taking associated with being perceived as “too-big-to-fail.”
The remainder of our paper is organized as follows: Section 2 reviews the related literature and Section 3 describes the data construction and descriptive statistics. Section 4 describes the methodology and results for the difference-in-differences and loan-level regression analysis used to compare risk-taking at TARP banks to non-TARP banks. Section 5 provides several robustness checks and Section 6 concludes.
Section snippets
Related literature
TARP was the first program in US history to make large government capital injections into privately owned banks. Although the banks were not nationalized, the injections were large enough for the government support to possibly have an effect on the risk profile of the banks during the crisis. Some papers have used international data to investigate how government capital injections affect banks’ lending and risk shifting. Micco and Panizza (2006) point out that government-owned banks may
Data and descriptive statistics
Our primary data are from the Survey of Terms of Business Lending (STBL). The STBL is a panel survey conducted by the Federal Reserve each quarter consisting of a stratified sample of insured commercial banks and US branches and agencies of foreign banks. The STBL collects data on gross commercial and industrial (C&I) loan originations made during the first full business week in the middle month of each quarter. The data are used for policy purposes to estimate the terms of loans extended
Empirical methodology and results
We use two approaches to evaluate the effect of TARP on bank risk-taking in more detail. Our first approach uses a basic difference-in-differences analysis to examine the change in the average risk of loan originations for TARP recipients compared to non-TARP recipients. The second approach uses the loan-level data to see if the injection of TARP funds affected risk-taking after controlling for other factors. We then consider the effect on changes in loan volume and offer several robustness
Robustness checks
This section provides several robustness checks to confirm the previous results and also provide more specificity on the interpretation of the results. In particular, we consider the dollar amount of the infusion, a matched pair analysis, differences in loan size category and the repayment of the TARP funds.
Conclusion
The Troubled Asset Relief Program involved a major infusion of government funds into the US banking system in an attempt to stabilize financial markets. The program was developed by congressional mandate; however, the purpose of the program was not entirely clear from the beginning. The program was originally portrayed as an effort to reduce the risk profile of banks by increasing bank capitalization. In this respect, the program even involved requirements on executive compensation that were
Acknowledgments
The views expressed are those of the authors and do not necessarily reflect those of the Board of Governors of the Federal Reserve System or its staff. The authors would like to thank Allen Berger, Mark Carey, Rochelle Edge, Scott Frame, Philipp Hartmann, Dmytro Holod, Christopher James, Jose Lopez, Michael Pagano, Peter Pontuch, Tara Rice, Tjomme Rusticus, Skander Van den Heuvel, Linus Wilson and participants in seminars at the Bocconi 2010 CAREFIN conference, FDIC/JFSR 11th Annual Bank
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