Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2016:10: TARP and Market Discipline: Evidence on the Moral Hazard Effects of Bank Recapitalizations

Jens Forssbaeck () and Caren Yinxia Nielsen ()
Additional contact information
Jens Forssbaeck: School of Economics and Management, Lund University
Caren Yinxia Nielsen: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: We examine the moral hazard effects of bank recapitalizations by assessing the impact of the U.S. TARP program on market discipline exerted by subordinated debt-holders using a sample of 123 bank holding companies over the period 2004-2013. Predicted distress risk has a consistently positive and significant effect on sub-debt spreads, suggesting the presence of market discipline. A higher bailout probability significantly reduces the risk-sensitivity of spreads for the full sample, indicating a moral hazard effect of recapitalizations. This appears to be a too-big-to-fail effect, as it is absent when the largest banks are dropped from the sample. Results indicate that it is transitory. We also find a large effect of the crisis, appearing both as a uniform rise in, and a heightened risk sensitivity of, sub-debt spreads during the crisis.

Keywords: Bank bailouts; moral hazard; distress risk; capital injections; TARP; CPP; market discipline; financial crisis

JEL-codes: E50; G01; G21; G28; H12

49 pages, June 13, 2016

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