Government Guarantees and Bank Risk Taking Incentives

This paper analyzes the effect of government guarantees on bank risk taking incentives. We exploit a natural experiment in which regulators remove the state guarantee of German Landesbanken which results in a deterioration in their credit rating, a loss in their franchise value and subsequently higher funding costs. This removal was announced in July 2001 and became effective in 2005 so that Landesbanken are 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. While Landesbanken do not differ from other banks in Germany in their lending practices before the removal of state guarantees, they significantly increase their bond issuances after 2001 to give loans to significantly riskier customers and at significantly lower rates afterwards. Furthermore, this trend is most pronounced for those Landesbanken with the largest decrease in expected ratings and franchise value. These results are consistent with banks starting to gamble in expectation of future loss of funding liquidity.