Safer Ratios, Riskier Portfolios: Banks’ Response to Government Aid

Abstract

We study the effect of government assistance on bank risk taking. Using hand-collected data on bank applications for government assistance under the Troubled Asset Relief Program (TARP), we investigate the effect of both application approvals and denials. To distinguish banks’ risk taking behavior from changes in economic conditions, we control for the volume and quality of credit demand based on micro-level data on home mortgages and corporate loans. Our difference-in-difference analysis indicates that banks make riskier loans and shift investment portfolios toward riskier securities after being approved for government assistance. However, this shift in risk occurs mostly within the same asset class and, therefore, remains undetected by the closely-monitored capitalization levels, which indicate an improved capital position at approved banks. Consequently, these banks appear safer according to regulatory ratios, but show a significant increase in volatility and default risk.