Do bailouts make banks “too interconnected to fail”?: the effects of TARP on the interbank market and bank risk-taking

Abstract

I investigate how the Troubled Asset Relief Program (TARP) affected the stressed interbank money market trading during the recent financial crisis via a difference-in-difference (DiD) design. I find that the TARP capital injection significantly enlarged the interbank exposure for the TARP recipients relative to others, particularly for banks in smaller size, with lower level of interbank trading and located in relatively poor economic conditions. I further test whether the distorted interbank liquidity position of the TARP recipients stimulated their credit risk appetite. I find that TARP recipient banks with larger interbank exposure also significantly shifted to riskier credit portfolios than others after the TARP implementation, suggested by estimates on forward- and backward-looking risk measures. Results are robust to the instrumental variable analysis, the sample self-selection model, the propensity score matching analysis, various placebo experiments and alternative econometric models. My results are most consistent with the “capital spillover” hypothesis that banks used the TARP capital to develop more interconnected interbank relationships, and the moral hazard effect that higher future bailout expectation and increased systemic relevance jointly construct a “new government safety net” for the TARP beneficiaries to take excessive credit risks under the implicitly perceived “too interconnected to fail” protection.