Scandinavian Working Papers in Economics

Knut Wicksell Working Paper Series,
Lund University, Knut Wicksell Centre for Financial Studies

No 2015/9: TARP and market discipline: Evidence on the moral hazardeffects of bank recapitalizations

Jens Forssbaeck and Caren Xinxia Nielsen
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Jens Forssbaeck: Knut Wicksell Centre for Financial Studies, Lund University
Caren Xinxia Nielsen: Knut Wicksell Centre for Financial Studies, Lund University

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-bigto-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

72 pages, October 1, 2015

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