Bailouts and Moral Hazard: How Implicit Government Guarantees Affect Financial Stability

38 Pages Posted: 19 Aug 2014 Last revised: 12 Dec 2014

See all articles by Mike Mariathasan

Mike Mariathasan

KU Leuven- Faculty of Economics & Business

Ouarda Merrouche

Bank of England

Charlotte Werger

European University Institute

Multiple version iconThere are 2 versions of this paper

Date Written: December 8, 2014

Abstract

The recent crisis has shown that systemically relevant banks in distress are likely to benefit from governmental support. This reduces their downside risk and leads to moral hazard, i.e. to incentives for these banks to assume excessive risks. In this paper we show empirically that implicit guarantees lead to more leverage and to a lower quality of bank capital; furthermore, we investigate which institutional characteristics are associated with a reduction in moral hazard. Our analysis combines bank balance sheet information from 92 countries with Fitch Support Ratings and World Bank survey data on governance and regulation. We find that a higher likelihood of being bailed out is associated with higher leverage and with lower levels of common equity. We find that external auditing, regulating the range of banks’ activities, and restricted access to Lender-of-Last-Resort facilities reduce moral hazard; financial sophistication, instead, appears to be conducive to risk-taking. We also find the moral hazard effect to be stronger after the Lehman default.

Keywords: banking, moral hazard, government guarantees, bailout

JEL Classification: G20, G21, G28

Suggested Citation

Mariathasan, Mike and Merrouche, Ouarda and Werger, Charlotte, Bailouts and Moral Hazard: How Implicit Government Guarantees Affect Financial Stability (December 8, 2014). Available at SSRN: https://ssrn.com/abstract=2481861 or http://dx.doi.org/10.2139/ssrn.2481861

Mike Mariathasan

KU Leuven- Faculty of Economics & Business ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

Ouarda Merrouche

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Charlotte Werger (Contact Author)

European University Institute ( email )

Villa Schifanoia
133 via Bocaccio
Firenze (Florence), Tuscany 50014
Italy

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