Economics

No surprise: TARP bailout encouraged banks to make riskier loans

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.

5 thoughts on “No surprise: TARP bailout encouraged banks to make riskier loans

  1. Is this guy serious. For years banks and mortgage lenders had been giving you money if you had a pulse. The big problem post meltdown was credit seizing up. Go and try and get a mortgage today and fnd out how easy it is.

    • It’s a piece of cake to get a loan. I work in real estate and still see people getting loans that shouldn’t..5% down and a 620 score (which isn’t much) will get you into a house up to 57% of your income. Their answer to the easy money recession is easy money.

  2. The study focuses on Commercial and Industrial loans; not residential mortgages. Yes, it is tougher to get a residential mortgage loan today. That is not the focus of the study or the author’s comments. The Federal government is subsidizing the rebuilding of bank capital and punishing savers. We socialized the losses of imprudent bankers and traders; will we be “shocked, shocked” when the next round of gambling goes bad? The community banks are not moving out on the risk curve because they know the regulators would prefer to eliminate them. 85% of bank deposits are in 32 institutions; the bureuacratic life is easier focusing on those 32 versus thousands of small local banks. It is no mystery why there is no robust recovery Beppo; at the margin, credit is still “seized up.”

  3. Are you for real? The whole point of TARP was for banks to make pretty much any loan, as opposed to nothing if they were let to fail. So a loan, any loan, is riskier than no loan. So yes, TARP did indeed encourage banks to make loans. Period. You just implicitly acquiesced to the success of TARP.

    And I have to say, you being one of the 2-3 loudest pro-bank, anti-reform voices in the AEI, you have to appreciate the subtle irony of your tone. You were beating the drum of government meddling in banking, suggesting that banks were not in need of regulation, which would stiffle “innovation” and hinder credit – and you had plenty of “innovation” and bogus loans pre-2007. Now Obama tried to fix the calamity caused by the banks, which did require jumpstarting credit flows, but you for some reason now dislike that! Have some professional integrity.

  4. Karl Rove, is this your new nom de plume?

    1. The opening sentence refers to “Obama’s economic policies,” and nowhere in the article is the name of the man under whose authority TARP began and proceeded for most of the larger bailouts. I realize that Republicans don’t remember ANYTHING that happened before 2009, but the fact that the name of George W. Bush does not appear here and Obama’s does tells me all I need to know about the bias of its author.

    2. The point of the article may be true, but how can we tell without what scientists call a “control?” Which in this case would be an analysis of the behavior of banks BEFORE 2008 and TARP. I think most of us would be extremely surprised if the finding was other than that banks made highly risky — not to say donwright foolhardy — loans for the five years before TARP. Anybody want to take me up on that? I didn’t think so.

    3. Even if the author’s conclusion is correct — that TARP-bailed-out banks are making riskier loans than those not bailed out by TARP — so what? The plain fact is that at the time TARP came into existence, NOBODY was making loans, risky or otherwise. Is the author saying that was a good thing? That the introduction of moral hazard by TARP outweighs the very real possibility that the worst recession since WWII might have turned into a Great Depression?

    Hey, why bring up stuff like that, when you can take a poke (incorrectly but who cares) at Obama? If this is the best AEI can do, it doesn’t justify its existence.

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