The U.S. Treasury Department recently created a bunch of charts highlighting the success of President Obama’s economic policies. Here’s one:
Shorter, TARP good. But those charts don’t tell the whole story of the costs associated with the bank bailouts. Here’s a handy rule of thumb: Bailouts lead to more bailouts. They encourage risky behavior by limiting downside. If some person or institution acts recklessly, don’t worry; Uncle Sucker will catch them if they fall. A new Fed study shows the the moral hazard issue came into play with banks that took TARP funds:
The Troubled Asset Relief Program involved a major infusion of government funds into the U.S. banking system in an attempt to stabilize financial markets. The program was developed by congressional mandate; however, the purpose of the program was not entirely clear from the beginning. The program was originally portrayed as an effort to reduce the risk profile of banks by increasing bank capitalization. …
However, the public response to the program also generated a significant push for banks to convert the funds into loan originations. Based on this purpose, banks were being encouraged to make more loans in an economic downturn which may have induced looser lending standards (Guner, 2008).
The results from the event study illustrate that the average risk rating at large TARP recipients increased more than at large non-TARP recipients following the capital infusions. Conversely, the risk of loan originations by small TARP recipients appears to have decreased relative to non-TARP recipients.
In our regression results, we find consistent evidence that the TARP capital injection significantly increased the risk of loan originations by the large banks receiving the funds and significantly decreased the risk of loan originations by the small banks receiving the funds.
Supporting evidence from interest spreads also indicates that the spreads on loans from large TARP recipients widened substantially following the TARP capital infusions.
Overall, we find that the degree of risk in commercial loans made by TARP recipients appears to have increased for large banks but decreased for small banks. …
In the effort to improve bank capitalization and safety and soundness, TARP may have reduced incentives to take on risk for small banks, yet, as a program implicitly expected to create additional lending for macro-stabilization, it may have increased incentives to take on risk for large banks. In addition, the use of government funds to support banks may have created incentives for excessive risk-taking through moral hazard.
1. Incentives matter. And bailouts create incentives for taking risks that might otherwise be shunned without government providing a backstop or safety net.
2. Bailouts and other government interventions also tempt government to then direct the private sector to do its bidding for whatever purpose it chooses—whether or not it makes economic sense. (See: housing bubble.)
3. Big banks still have a funding edge over smaller banks, even with the sorts of risky practices the Fed describes. Why? Because markets still assume Too Big To Fail is firmly in place.