Quelle surprise. Or should we say, was fur eine Überraschung?
A new working paper from the European Central Bank describes the augmenting effect of government guarantees on bank risk-taking. In a nutshell:
Overall, the results suggest that public guarantees may be associated with substantial moral hazard effects. The unique identification scheme permits us to establish a causal relationship between public guarantees and banks’ risk taking.
The case study here is interesting.
The idea is to look at a period without financial turmoil, and for non-’Too Big To Fail’ banks, in order to isolate just the effect of the government guarantee on banks’ balance sheets. And so, the authors use the former guarantees on the German Landesbanks (an FT Alphaville favourite) to demonstrate their thesis.
As a refresher, Landesbanks enjoyed public guarantees up until a 2000 European court decision deemed them uncompetitive. The guarantees were subsequently transitioned out between 2001 and 2005, and the paper looks at developments in that period.
And boy, were there developments.
There are annoyingly statistical Z-scores involved here, but in basic terms, the Landesbanks duly curbed their risk-taking once the guarantees were removed:
The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. At the same time, the banks also increased interest rates on their remaining borrowers and reduced the average loan size. The effects are economically large: the Z-Score of average borrowers increased by 7.5% and the average loan size declined by 17.2%. Remaining borrowers paid 46 basis points higher interest rates, despite their higher quality.
The corollary is of course, that they didn’t care so much about risk while having those guarantees. In fact, as FT Alphaville has noted before, they used the 2001-2005 period to rush out and buy high-yielding subprime debt from the States. Nice.
So in addition to distorting bank debt issuance (think weaker banks with a ‘strong’ government backing rushing to sell bonds) on the liability side of banks’ balance sheets, it seems government guarantees also distort lending on the asset side.
Here’s the unsurprising conclusion from the paper — with policy implications:
In light of the extensive public guarantees extended in the wake of the recent financial crisis, the findings of this paper have important policy implications: The results suggest that a credible removal of guarantees will be essential in reducing the risk of potential future financial instability. They also support recent initiatives to impose capital surcharges on the largest banking institutions, which may benefit either from an explicit or an implicit guarantee (e.g. Swiss TBTF Commission of Experts, 2010). Higher capital in these banks may help offset the incentives provided by the public guarantees imposed during the crisis.
Easier said then done, of course.
It’s worth remembering that recent Irish turmoil was sparked in large part by expected expiration of the country’s own guarantee scheme, in which the ailing sovereign promised to protect billions worth of bank deposits and liabilities.
In fact, now that Ireland’s been bailed out, we have guarantees of a very different sort. The eurozone itself is now on the hook for Irish debt and Greek and … (gulp).
(As a footnote, many of the subprime-laden Landesbanks ended up being rescued, nationalised and re-guaranteed by the German government after the financial crisis.)
Related links:
Thou shalt not bluff - FT Alphaville
Stress tests sovereign support = senseless – FT Alphaville
Credit distortion de crise – FT Alphaville