Implicit and explicit government guarantees and their impact on bank risk.

Abstract

This thesis investigates the impact of implicit and explicit government guarantees on bank risk and financial fragility. It is comprised of three chapters. The first chapter, "Dualism of Government Guarantees: Evidence from the 2005 FDI Reform Act", examines the trade-off between stability and moral hazard induced by deposit insurance. I use the Federal Deposit Insurance Reform Act of 2005 as an exogenous shock to the existing insurance scheme in the US and study its impact on bank risk and financial stability. This reform raised the coverage limit for individual retirement accounts (IRAs) from $100,000 to $250,000. I report evidence of a moral hazard effect, in the form a higher bank liquidity and insolvency risk, caused by this reform. In addition, I show banks more impacted by the 2005 reform were significantly less prone to failure during the Global Financial Crisis (GFC).

The second chapter, "What can Volatility Smiles tell us about the Too Big to Fail problem", exploits the information content of option markets to offer insight into the Too Big to Fail (TBTF) problem for banks. Using option prices, I construct a forward-looking measure of bank exposure to significant price drops (i.e. tail-risk) and use this to examine cross-sectional differences between large banks and smaller banks. I document a permanent increase in the average tail-risk of the U.S. banking industry following the GFC, except for banks that were explicitly designated as systemically important (i.e. banks with more than $50B in assets). I provide evidence that the post-crisis difference in tail-risk for banks above and below the $50B threshold owes to the TBTF status of systemically important banks that was reinforced by the Dodd-Frank Act.

The third and final chapter, "De Facto Bank Bailouts", is based on a working paper co-authored with Phong Ngo. In this paper we show that the likelihood a defaulting sovereign is granted an International Monetary Fund (IMF) loan increases with U.S. banks' exposures to its country. We argue the U.S. government uses its voting power in the IMF to direct IMF funds to countries where U.S. banks stand to lose the most from the sovereign default - a de facto bailout. Consistent with this, we show that (1) U.S. Congressional voting on IMF funding increases is consistent with special (banking) interests; and (2) U.S. bank stocks' market reaction to the announcement of an IMF loan increases with its exposure to the defaulting sovereign. Show more