Capital infusions and Bank risk-taking behaviour

Abstract

Despite theoretical predictions on the ill effects associated with capital infusions, the Global Financial Crisis (GFC) brought them into mainstream banking around the world. Empirical evidence on capital infusions during GFC supports the existence of moral hazard problem. However, what is not clear is whether the increase in bank risk post-capital infusions is due to an increase in bank risk-taking behaviour (moral hazard) or simply reflects an increase in the average firm-level risk due to poor economic conditions. We try to disentangle this issue by using capital infusion data in the Indian banking industry, where government capital infusions in public sector banks happen in all economic conditions and hence allow us to control for a non-crisis environment. Our results strongly support the moral hazard problem in banks, surrounded by no apparent economic crisis. The results are also independent of the bank's propensity to take risks and its financial health. One major implication of our findings is that repeated capital infusions to protect banks can be detrimental as it increases the fiscal risk of the country.