Risk-Shifting, Regulation and Government Assistance

Abstract

This paper examines an episode when policy response to a financial crisis effectively incentivized financial institutions to reallocate their portfolios toward safe assets. Following a shift to a regime of enhanced regulation and scaled-down public assistance during the Savings and Loans (S&L) crisis in 1989, this paper finds that S&Ls with a high probability of failure increased their composition of safe assets relative to S&Ls with a low probability of failure. The findings also show a shift to safe assets among stock S&Ls relative to mutual S&Ls, thereby providing evidence of risk-shifting from equity-holders to debt-holders of stock S&Ls prior to the regulatory reforms. These findings show that credible signals to shareholders around government assistance will be crucial for the policies aimed at reducing moral hazard (such as the Orderly Liquidation Authority under Title II of the Dodd-Frank Act) to succeed. This paper identifies the effect of the policy change by developing a new Bayesian estimation method for causal studies.

Keywords: Bank failures, Bailouts, Moral hazard, Risk-shifting, Bayesian inference, Savings and Loans Crisis, Markov chain Monte Carlo (MCMC), Federal Savings and Loans Insurance Corporation (FSLIC), Resolution Trust Corporation (RTC)

JEL Classification: C11, C31, C33, G21, G33, G38