The Impact of Public Guarantees on Bank Risk Taking: Evidence from a Natural Experiment
Review of Finance 18 (2014), 457-488
48 Pages Posted: 13 Jan 2010 Last revised: 17 Feb 2015
Date Written: February 27, 2013
In 2001, government guarantees for savings banks in Germany were removed following a lawsuit. We use this natural experiment to examine the effect of government guarantees on bank risk taking. The 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. The evidence implies that public guarantees may be associated with substantial moral hazard effects.
Keywords: banking, public guarantees, credit risk, moral hazard, market discipline
JEL Classification: G21, G28, G32
Suggested Citation: Suggested Citation