TARP Announcement, Bank Health, and Borrowers' Credit Risk
35 Pages Posted: 19 Mar 2010 Last revised: 11 Dec 2015
Date Written: December 1, 2015
Theory suggests that unhealthy banks exhibit more pronounced flight-to-quality behavior during financial crises and, hence, the infusion of capital through unhealthy banks is less effective in relieving the liquidity shocks of vulnerable borrowers. We test these predictions by investigating how the financial health of leading U.S. banks influenced their borrowers’ credit risk surrounding the announcement of the Troubled Asset Relief Program (TARP). Changes in borrower credit risk, measured by credit default swap (CDS) spreads, should reflect the expected relief from liquidity shocks and other benefits of rescuing banks, such as maintaining the existing lending relationships. Consistent with the theory, prior to the TARP capital infusions, unhealthy banks’ borrowers with high leverage experienced a greater increase in their credit risk relative to similar healthy banks’ borrowers. Following the event, the CDS market anticipated less liquidity relief to these vulnerable unhealthy banks’ borrowers, but more liquidity relief to the vulnerable healthy banks’ borrowers.
Keywords: Financial crisis, Government bailouts, Banking relationship, Systemic risk, Liquidity provision, Credit default swap, Credit risk
JEL Classification: G20, G21, G28
Suggested Citation: Suggested Citation