The impact of public guarantees on bank risk taking

The Impact of Public Guarantees on Bank Risk Taking: Evidence from a Natural Experiment, a paper by Reint Gropp, Christian Grundl and Andre Guttler dated April 10, 2010, is clear and unsurprising. The abstract is below:

Abstract: In 2001, government guarantees for savings banks in Germany were removed following a law suit. We use this natural experiment to examine the effect of government guarantees on bank risk taking, using a large data set of matched bank/borrower information. The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. At the same time, the banks also increased interest rates on their remaining borrowers. The effects are economically large: the Z-Score of average borrowers increased by 7% and the average loan size declined by 13%. Remaining borrowers paid 57 basis points higher interest rates, despite their higher quality. Using a difference-in-differences approach we show that the effect is larger for banks that ex ante benefited more from the guarantee. We show that both the credit quality of new customers improved (screening) and that the loans of existing riskier borrowers were less likely to be renewed (monitoring), after the removal of public guarantees. Public guarantees seem to be associated with substantial moral hazard effects.

We need to apply this common sense to reform of Fannie and Freddie. Any reform that does not include them is simply a fraud on the American public.