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Government Assistance and Moral Hazard: Evidence from the Savings and Loan Crisis

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Abstract

When regulators intervene to rescue failing financial institutions, they may lead banks to expect future assistance and increase their risk-taking. To avoid incentivizing risky behavior, regulators often try to signal that they will not assist banks in a future crisis. Regulations passed during the savings and loan (S&L) crisis in the 1980s provide a rare example of policies that in fact discouraged risk-taking. After a wave of S&L failures, the Federal Savings and Loan Insurance Corporation (FSLIC) liquidated or sold some failed S&Ls but assisted others to keep them in operation. In 1989, however, the FSLIC closed. A new regulatory agency was prohibited from assisting failed institutions, which signaled the suspension of future assistance. Padma Sharma examines how suspending assistance to failed S&Ls in 1989 affected the balance sheets of operational S&Ls. She finds that S&Ls responded to the change in policy differently depending on ownership structure: stock S&Ls increased their composition of safe assets relative to mutual S&Ls. If government assistance had remained feasible, stock S&Ls likely would have continued taking risks, lending an additional $2.14 billion and reducing their holdings of securities by $4.5 billion. In contrast, mutual S&Ls did not engage in excessive risk-taking even when government assistance was feasible, so they had little incentive to further reduce risk-taking when assistance was suspended.

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  • Padma Sharma, 2022. "Government Assistance and Moral Hazard: Evidence from the Savings and Loan Crisis," Economic Review, Federal Reserve Bank of Kansas City, vol. 107(no.3), August.
  • Handle: RePEc:fip:fedker:94766
    DOI: 10.18651/ER/v107n3Sharma
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    1. Cordella, Tito & Yeyati, Eduardo Levy, 2003. "Bank bailouts: moral hazard vs. value effect," Journal of Financial Intermediation, Elsevier, vol. 12(4), pages 300-330, October.
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    JEL classification:

    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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