NY Fed Study Says Government Backstop Increases Bank Risk Appetite

NY Fed Study Says Government Backstop Increases Bank Risk Appetite
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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.

“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.”

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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.

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Mark Melin is an alternative investment practitioner whose specialty is recognizing a trading program’s strategy and mapping it to a market environment and performance driver. He provides analysis of managed futures investment performance and commentary regarding related managed futures market environment. A portfolio and industry consultant, he was an adjunct instructor in managed futures at Northwestern University / Chicago and has written or edited three books, including High Performance Managed Futures (Wiley 2010) and The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill 2008). Mark was director of the managed futures division at Alaron Trading until they were acquired by Peregrine Financial Group in 2009, where he was a registered associated person (National Futures Association NFA ID#: 0348336). Mark has also worked as a Commodity Trading Advisor himself, trading a short volatility options portfolio across the yield curve, and was an independent consultant to various broker dealers and futures exchanges, including OneChicago, the single stock futures exchange, and the Chicago Board of Trade. He is also Editor, Opalesque Futures Intelligence and Editor, Opalesque Futures Strategies. - Contact: Mmelin(at)valuewalk.com

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