Research Spotlight

Bad News on Bank Bailouts

The US government- sponsored bailout during the 2008 global financial crisis may have lowered credit supply from recipient banks. This was the surprising finding highlighted by Professor Anand Srinivasan of the Centre for Advanced Financial Research and Learning, Reserve Bank of India and National University of Singapore in a Finance area seminar at the Indian School of Business on November  22, 2017.

The global financial crisis announced itself in 2008 with the collapse of several august and seemingly unassailable financial institutions.  Investment bank Bear Sterns was one of the first to go under. Then Lehman Brothers filed for bankruptcy. United State banks Washington Mutual and Wachovia appeared to be next in line.

Faced with the prospect of near meltdown in the financial sector, in October 2008, the US Department of Treasury inaugurated the Troubled Assets Recovery Programme or TARP, a $700 billion bank recapitalization scheme authorized by the US Congress. Along to a report in a St Louis Federal Reserve publication, some 707 institutions were bailed out by the US Treasury in exchange for preferred stock or debt securities. The central aim of the bailout, according to senior officials quoted at the time? Increase lending.

TARP was the largest bailout in US history. How did it affect the lending behaviour of banks during the financial crisis? This question lies at the heart of a recent paper by Professor Anand Srinivasan of the National University of Singapore and the Reserve Bank of India and his co-authors Yupeng Lin and Xin Liu. Professor Srinivasan, who is currently also a Director of Research at the RBI’s Centre for Advanced Financial Research and Learning (CAFRAL) presented his research as part of the Finance seminar series at the ISB on November 22, 2017.

The expectation of the policymakers was that some of the benefit would be passed on to the borrowers. Counter-intuitively, however, Professor Srinivasan and his co-authors found that the bailout for the bank was bad news for their borrowers: the borrowers had a negative stock price reaction on the date of announcement of the TARP.

Why was the bank bailout bad news for borrowers? Professor Srinivasan and his co-authors were able to identify two key channels. First, building on the insights of a paper by Viral Acharya and his co-authors, they confirmed that bailed out banks are more likely to hoard liquidity, perhaps for acquisitions of weaker institutions in times of financial crisis.

Professor Srinivasan highlighted a second, hitherto overlooked mechanism that explains liquidity hoarding.  The TARP also resulted in increased regulatory scrutiny. Among other factors, the US government had more representation on the board. These banks had disproportionately more likely to be fined, not only on issues related to TARP but other issues as well. As Professor Srinivasan put it, once you let the taxman in your house, they find other skeletons in the closet. Due to this regulatory scrutiny, firms tended to keep aside cash to pay actual or potential fines.

One real economy effect of such precautionary savings by TARP-recipient banks? Borrowers in the sample cut investment.

Would similar concerns of liquidity hoarding and lowered lending also apply to the proposed recapitalization of public sector banks, announced by the RBI? Professor Srinivasan noted that on the one hand, the reduction of lending by Indian public sector banks was primarily a result of voluminous non-performing assets. Public sector banks would be more likely to comply with government directions to increase lending, if they had the capacity to lend. On the other hand, however, Professor Srinivasan argued that there were deeper structural problems in the Indian state-owned banks, which were not necessarily present in the American economy. According to him, the effects of the bank capitalization remained an open research question, one that he looked forward to examining.

The abstract of the paper is as below:

Unintended consequences of government bailouts: Evidence from bank-dependent borrowers of large banks
Using the Troubled Asset Relief Program (TARP) as a laboratory, this paper examines the impacts of bank bailouts on bank-dependent clients. We find that large TARP recipient banks reduce credit supply to dependent borrowers in the post-TARP period. This effect is more pronounced for recipient banks that hoard liquidity. This negative credit supply reduction causes bank-dependent borrowers to become more constrained financially. Ex-ante analysis also reveals a significant valuation loss for these borrowers around the announcements of their main banks’ TARP approvals. We further show that a large fraction of credit supply reduction is due to regulatory uncertainty.