Government support to banks through the provision of explicit or implicit guarantees affects the willingness of banks to take on risk by reducing market discipline or by increasing charter value. We use an international sample of bank data and government support to banks for the periods 2003-2004 and 2009-2010. We find that more government support is associated with more risk taking by banks, especially during the financial crisis (2009-10). We also find that restricting banks’ range of activities ameliorates the moral hazard problem. We conclude that strengthening market discipline in the banking sector is needed to address this moral hazard problem.
Bank bailouts during and after the 2007–2009 financial crisis have reignited the debate on the effect of government support on banks’ management incentives and on the distortions it causes in competition in the banking sector. Explicit and implicit government support can influence banks’ willingness to take on risk through two channels: by reducing market discipline and/or by increasing the banks’ charter value. According to the market discipline hypothesis, government support of banks decreases the incentive of outside investors (depositors, creditors, and shareholders) to monitor or influence bank risk taking. Risk-shifting may occur if deposit insurance is not fairly priced (Merton,1977) or if governments provide guarantees to holders of bank debt (Flannery and Sorescu,1996). Under the charter value hypothesis, government support decreases banks’ funding costs as both depositors and creditors demand lower rates.