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

Authors: Gara Afonso, João 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 their disorderly 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 paper studies the effect of potential government support on banks’ appetite for risk. Using balance-sheet data for 224 banks in 45 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 show similar effects on net charge-offs and for U.S. banks only.
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