Bank Risk Taking and Liquidity Creation Following Regulatory Interventions and Capital Support

When banks are troubled, authorities often engage in regulatory interventions and/or provide capital support to resuscitate the bank and reduce bank risk taking. An unintended effect of such actions may be a reduction in bank liquidity creation, with possible adverse consequences for the economy as a whole. This paper tests hypotheses regarding the effects of regulatory interventions and capital support on bank risk taking and liquidity creation using a unique dataset over the period 1999-2009. Our short-run analyses suggest that both types of actions are associated with statistically and economically significant reductions in risk taking and liquidity creation. These results are highly robust, and stand up to using an instrumental variable approach to deal with potential endogeneity. Our long-run analyses suggest that 1) there are no significant changes in risk taking and liquidity creation in the years preceding regulatory interventions and capital support, consistent with a causal interpretation of our results; 2) most of the effects occur shortly after these actions are taken; and 3) the effects remain in place in the long run. Thus, both types of actions may have important intended consequences (risk reduction) and unintended consequences (diminished liquidity creation), with implications for policymakers.