Economic Policy Review
Do "Too-Big-to-Fail" Banks Take On More Risk?
December 2014, Volume 20, Number 2    
JEL classification: G00,G21,G28

Authors: Gara Afonso, João A. C. Santos, and James Traina

The notion that some banks are “too big to fail” builds on the premise that governments will offer support to avoid the adverse consequences of disorderly bank failures. However, this promise of support comes at a cost: Large, complex, or interconnected banks might take on more risk if they expect future rescues. This article studies the effect of potential government support on banks’ appetite for risk. Using balance-sheet data for 224 banks in forty-five countries starting in March 2007, the authors find higher levels of impaired loans after an increase in government support. To measure support, they rely on Fitch Ratings’ support rating floors (SRFs), a new rating that isolates potential sovereign support from other sources of external support. A one-notch rise in the SRF is found to increase the impaired loan ratio by roughly 0.2—an 8 percent increase for the average bank. The authors obtain similar results when they assess the effect of increased support on net charge-offs and when they narrow their sample to U.S. banks only.
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