Abstract - Government Guarantees and Bank Risk Taking Incentives

This paper analyzes the effect of government guarantees on bank risk taking incentives. We exploit the removal of state guarantee for German Landesbanken which results in a deterioration in their credit rating, higher funding costs, and a loss in their franchise value. This removal was announced in July 2001 and became effective in 2005 and Landesbanken were still allowed to issue state-guaranteed bonds during the four-year transition period. We analyze the lending behavior of Landesbanken around the announcement of the removal of the guarantees relative to non-protected private banks using a difference-in-difference framework. We find that Landesbanken significantly increase risk after July 2001 relative to the period before and relative to other banks. Analyzing a subsample of loans issued by Landesbanken, we show that in particular Landesbanken with the highest expected decrease in franchise value increase risk. We also document that Landesbanken significantly increased their bond issuance volume during the transition period. Our results are consistent with theories on gambling and provide implications for the current debate on the optimal removal of government guarantees.

Back to overview