The New York Federal Reserve, which oversees the largest US banks, is asking the question “Do ‘too big to fail banks‘ take on more risk if they are likely to receive a government bailout?”  Their answer: yes.

US Bank

“Historically, commentators have expressed concerns that TBTF status encourages banks to engage in risky behavior,” the report notes. “However, empirical evidence to substantiate these concerns thus far has been sparse.”

Using ratings from Fitch, the report, fourth in a series of twelve covering issues surrounding large banks, examines how changes in the perceived likelihood of government support impact bank lending practices.

Too big to fail banks: Measure of risk is “impaired loans”

Noting that gauging government support is a “challenge,” the report considered the Support Rating Floors (SRFs), which Fitch introduced in 2007. The rating isolates the likelihood of government support from other forms of support such as from parent companies or institutional investors. The report did not measure the increase in OTC derivatives as a measure of risk.

Seeking to determine if perceived government support translated into riskier loan portfolios, the report’s authors, Gara Afonso, an economist in the Federal Reserve Bank of New York’s Research and Statistics Group, João Santos, a vice president in the Research and Statistics Group, and James Traina, a senior research analyst in the Research and Statistics Group, considered  “bank-level data for 224 banks in 45 countries that includes Fitch ratings and balance-sheet information from March 2007 to August 2013.”

Too big to fail banks: Risk increases over time

Measuring the riskiness of a bank’s lending business by the ratio of impaired loans to total assets, the researchers look at the effect on a bank’s impaired loans one to eight quarters after a change in its SRF.  The study then notes a change in impaired loans over time. “A one-notch rise in the SRF increases the impaired loan ratio by roughly 0.2—an 8 percent increase for the average bank. Importantly, this effect steadily increases through time and persists even eight quarters after a change in support,” the report notes.

Citing other research papers on the topic, the report concludes: “Our findings therefore lend support to the claim that “Too-Big-to-Fail” banks engage in riskier activities by taking advantage of the likelihood that they’ll receive government aid.”

While this might not come as a surprise, it is nonetheless noteworthy that the issue is finally documented.