Charter values, bailouts and moral hazard in banking

Abstract

In this study, we examine the disciplining effect of charter values for U.S. insured depository institutions during the 1995–2012 period and the impact of government bailouts on bank risk-taking incentives following the 2008 financial crisis. Bank charter value arises from the monopolistic rents in the imperfect competition in the highly regulated banking industry. It may offset moral hazard resulting from government safety net. We analyze the impact of bank charter values, jointly with bank leverage, within the framework suggested by the Marcus (J Bank Financ 28:2259–2281, 1984) model, which originally introduced the disciplining role of bank charter value. We demonstrate that while high charter values reduce risk-taking incentives, low charter values are positively associated with higher risk-taking incentives in the shareholder value maximization problem. We also show that the impact of government bailouts (Troubled Asset Relief Program, or TARP) on bank risk taking is non-monotonic: It increases risk-taking incentives for bailout recipients relative to non-recipients for “weak” institutions with low charter values and high leverage, while the opposite is true for “strong” institutions with high charter values and low leverage.