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Hard evidence: bailed out banks take more risk

By Finance Addict, a former banker

Politicians, Treasury Secretaries, etc. would have you believe that “moral hazard” is something we should only worry about in the abstract, in the future, when they’ve moved on to another job. But now a study confirms with hard facts: moral hazard–it lives.

Researchers have asked for some time whether and how bailouts might affect banks’ risk-taking. Would they run wild, aware of the high likelihood of being bailed out again if they ran into trouble? Or would they ease off precisely because they’d now be assured of lower financing costs and long-term survival, and therefore would want to avoid doing anything that might cause regulators to take that valuable banking license away? More daring or more discipline?

Each of these camps had its underpinnings yet the question was a difficult one to study. Why? Because, generally speaking, the developed Western countries didn’t really do bank bail-outs. [Insert smirk here.]

But then came 2008 and its bailout-palooza. And so, thanks to hundreds of billions of taxpayer dollars and an alphabet-soup of bank welfare programs, this question can now benefit from the availability of real-life, empirical data. (Cloud, silver lining and all that.)

Ran Duchin and Denis Sosyura of the University of Michigan looked at the U.S.’ Capital Purchase Program. You may recall that this became the centerpiece of TARP once Hank Paulson decided that the money would be better spent directly buying into the banks as opposed to overpaying them for dodgy asset-backed bonds. (Mind you, other parts of TARP were spent overpaying for dodgy asset-backed bonds.)

The CPP lasted a little more than a year and invested $205 billion of taxpayer funds into various qualifying institutions. Not every bank that filled out the 2-page application was successful in gaining access. Others were approved but ultimately decided not to take the funds (probably because of the attached restrictions on pay and on paying out dividends.) In the end, 707 financial institutions received the funds.

Duchin and Sosyua looked at a sample of 529 public firms that were eligible for CPP and slotted them into categories based on whether they applied, whether they were approved and whether they ultimately took the money. They controlled for non-random selection (via measures of the banks’ financial condition, performance, size and crisis exposure); for changes in national and regional economic conditions; and finally for potential distinctions in credit demand.

They then viewed the banks’ CPP participation status in comparison with their subsequent risk appetite as demonstrated by (1) their consumer mortgage credit approvals or denials (viewed on a risk-profile controlled, application-by-application basis); (2) their participation in syndicated corporate loans for riskier credits and; (3) the risk profile of their investment asset portfolios. What did they find?

For mortgages the bailed-out banks increased their risk–

“after CPP capital infusions, program participants tilted their credit origination toward higher-risk loans by tightening credit standards for the relatively safer borrowers and slightly loosening them for riskier borrowers.”

–while at the same time ensuring that they didn’t trip off any alarms

“This pattern would be consistent with a strategy aimed at originating high-yield assets, while improving bank capitalization ratios, since the key capitalization ratios do not distinguish between prime and subprime mortgages.”

Likewise, for corporate loans

“the fraction of CPP recipients in loans to borrowers with lower credit ratings has increased after CPP compared to nonrecipients.”

Finally, not only did the CPP recipients buy more investment securities than non-bailout recipients, but also riskier ones at that!

“[T]he total weight of investment securities in bank assets increased by 5.3% after CPP relative to non-recipient banks. More importantly, the increase in the allocation to investment securities at CPP participants was primarily driven by higher allocations to riskier securities, which increased at CPP banks by 6.2% after CPP relative to nonrecipients.”

Looking specifically at CPP recipients vs. those who applied but were rejected from the program, the authors found that the average yield on the bailed-out banks portfolios increased by 9.4%!

“Overall, the analysis of banks’ investment portfolios suggests that CPP participants actively increased their risk exposure after being approved for federal capital. In particular, CPP recipients invested capital in riskier asset classes, tilted portfolios to higher-yielding securities, and engaged in more speculative trading, compared to nonrecipient banks with similar financial characteristics.”

Moving from this granular level to a bank-wide basis, the authors found that the CPP banks increased asset risk (using ROA & earnings volatility as proxies) while decreasing their leverage (perhaps because they knew that regulators would be keeping an eye on this metric in addition to the capitalization ratio.)

What does all this mean and how should this shape actions in the future?

The bail-out itself increased our chances of having the bail the banks out all over again. Moral hazard is no longer in the realm of the abstract. Further, my guess is that the bailed-out banks took on more risk so that they could earn enough to speed repayment of the aid and therefore escape the onerous strings attached. So perhaps the limits on executive compensations, dividends, etc. in a perverse way increased our chances of having to bail the banks out all over again.

Finally, as the data on the mortgages show, banks are very good at gaming the system to make the figures work in their favor. How on earth do we get around this? Capital requirements like those contemplated for SiFis now seem to me grossly inadequate. Perhaps the answer is a Tobin tax that would force banks to pre-fund their eventual bailouts. And I say eventual because I don’t believe for a second that Dodd-Frank will do anything to enable wind-downs–when the next crisis comes the TBTFs will likely be bailed out. And we can start the whole messy process all over again.

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4 Comments

  1. fresno dan says:

    I would suggest we let them FAIL. Eventually stockholders and bondholders who have money to invest in such institutions will not have money to invest in such institutions, and there will stop being such institutions.

    Of course, as long as we have bailouts, and government officials and FED officals who think the WORST THING IN THE WORLD is a bank investor taking a loss, we will continue to have “heads the bank wins, tails the taxpayer loses” finance. After all, the banks are behaving rationally. Heck, if you give me money to go to Las Vegas, and I keep the winnings, and you take the losses….

    • David Lazarus says:

      You also need to consider that the people who regulate these banks, possibly also have ambitions to work in the banks that they regulate. Then the politicians get the largest share of political contributions from banks, so they will not bite the hand that feeds them. Then look at them gutting of any regulation by the politicians who are meant to represent the voter but are more interested in representing their paymasters. That means the US is effectively condemning the world to another Depression. Unless the banks are deleveraged and eliminate risks there is only one question. When will it blow up again?