Determinants of the Allocation of Funds Under the Capital Purchase Program

During 2008-09, as part of a wide-ranging rescue operation, the US Treasury poured capital infusions into a great many domestic financial institutions under the Capital Purchase Program (CPP), thus helping to avert a complete collapse of the US banking sector. In carrying out this effort, government regulators had to distinguish between those banks deserving of being bailed out and those that should be allowed to fail. The results of this study show that the CPP favored larger financial institutions whose potential failure represented higher degrees of systemic risk. This allocation of CPP funds was cost-effective from the point of view of taxpayers, as such banks reimbursed the government for their CPP bailouts sooner than expected. In contrast, smaller banks that were heavily into mortgage-backed securities, mortgages, and non-performing loans were less likely to be bailed out and, if they did receive CPP help, took longer to repurchase their shares from the Treasury. Several explanations of such allocation decisions are proposed in this paper, including adverse selection of the mortgage products kept on banks’ books and the Treasury’s approach to distinguishing between insolvent and temporarily illiquid institutions.