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1 August 2014 CFA Institute Journal Review

The Impact of Public Guarantees on Bank Risk-Taking: Evidence from a Natural Experiment (Digest Summary)

  1. Servaas Houben, CFA

Public guarantees on bank lending can result in moral hazard problems in which banks take on excessive risk. The removal of public guarantees for German savings banks in 2001 allows the authors to assess their effect on bank risk taking. The risk taking of savings banks and other banks without public guarantees converges when savings banks’ guarantees are removed.

What’s Inside?

The authors assess the impact of the removal of public guarantees on German savings banks over the period of 1996 to 2006. They apply a difference-in-differences statistical method for comparing the risk behavior of savings banks with that of nonsavings banks (i.e., commercial, cooperative, and credit banks). Savings banks reduce their credit risk after guarantees are removed. Furthermore, they increase their capital asset ratios, increase their deposit funding ratios, and reduce their risk-sensitive debt after public guarantees are removed. The borrower quality of savings banks increases, and these banks in general increase their monitoring of new customers.

How Is This Research Useful to Practitioners?

The interest rate and credit environments are important factors for decision makers in finance. Government guarantees on the banking system are not uncommon, and previous research has shown it is not straightforward to assess the impact of these guarantees. On the one hand, guarantees might stimulate risk taking by banks because of reduced monitoring and market discipline. On the other hand, the benefit of having this guarantee, which can be viewed as a subsidy, might be too valuable to risk losing it and thus lead to reduced risk taking.

The authors’ study is unique because they focus on a homogeneous sample of banks in a single country. Furthermore, the change in market circumstances is the result of a court order, which can be viewed as an exogenous event. The authors show that the risk behavior of savings and nonsavings banks was significantly different when the public guarantees were in place. But after these guarantees were removed, the risk taking of savings and nonsavings banks became more aligned, which indicates that the implementation of guarantees results in more risk taking by banks.

In addition, the authors analyze the effect of the removal of guarantees on such savings bank borrower characteristics as interest rates, loan sizes, and credit scores. The results show that, on average, borrower quality increases after guarantees are removed. Moreover, loan sizes are reduced, and interest rate margins increase. Thus, in terms of the borrower dataset, savings banks reduce their risk taking after guarantees are removed.

Next, the authors assess the effect on savings bank bonds by analyzing the spread over the risk-free rate. Savings banks’ spreads increase significantly after the removal of public guarantees, showing that market participants adjust their view on savings banks’ default probabilities upward when the guarantee is removed.

Lastly, after the removal of guarantees, banks generally increase their new customer screening, and additional monitoring also takes place for existing customers.

This research might be particularly interesting for financial professionals whose focus is yields and spread analysis, as well as for analysts of the banking sector.

How Did the Authors Conduct This Research?

To assess the behavior of savings banks, the authors use the 1996–2006 German Savings Banks Association dataset. They use the Bankscope financial statements to define the control group, which consists of nonsavings banks (i.e., commercial, cooperative, and credit banks) in Germany.

They then define their risk-taking parameters, the first one being the Z-score, which measures the risk of default/insolvency. The second measure is the standard deviation of the return on assets, and the third is the loan volume. The authors use a standard difference-in-differences methodology to assess the difference between the behavior of savings and nonsavings banks. They find that savings banks reduce their volume of loans and risk taking when their guarantees are removed. Furthermore, both savings and nonsavings banks increase their capital asset ratio after the removal of the guarantees, but only savings banks increase their deposit funding ratio and decrease their reliance on risk-sensitive debt.

To assess savings bank borrower characteristics, the authors gather borrower data mainly from small- and medium-sized enterprises. Customer data are then linked to a group of savings banks instead of a particular bank, and loan size is defined as the aggregate of outstanding loans. Lastly, they control for regional differences by taking local GDP, indebtedness, and business climate into consideration. The authors show that borrower quality increases after the guarantees are removed.

They strengthen the reliability of their results by performing a regression with lagging variables, doing robustness checks, and changing the selection criteria for commercial banks to be included in the dataset. The results are not sensitive to these changes.

Abstractor’s Viewpoint

This research is relevant for financial professionals because the economic crisis has led to increased discussion regarding what types of government support for markets are desirable. Surprisingly, risk-based regulation does not have the same impact as state guarantees, although the goal of motivating prudent business behavior is the same. Because banking regulations affect the work of many financial professionals, this research will appeal to a wide range of people working in the industry.

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