Government Guarantees Encourage Banks To Take More Risks, Not Lend Money, Study Finds

Government guarantees lead not to more lending but to more risk-taking by banks, according to a new research study of more than 2,200 financial institutions around the world. Dulani Jayasuriya, a candidate for a doctorate in finance at the National University of Singapore, made the finding in a not-yet-published study based on data collected by central banks and other financial authorities in 78 countries between 2001 and 2011.

“The surprising find is usually when you give money to these banks you expect them to reduce their risk,” Jayasuriya said in an interview with Australia’s ABC News. “But what they actually do is they increase their risk taking and they reduce their lending.”

Jayasuriya presented her research at a financial conference in Sydney last week, a confab organized by the Institute for Global Finance at the University of New South Wales, ABC News reported. She said her study found that government guarantees for banks considered crucial to the stability of a banking system were especially worrisome.

“When you think a bank is going to be bailed out, even creditors, people who lend money to the banks, they have less incentive to monitor,” the researcher said. “Basically, it’s like, ‘Mum and Dad will take care of you, I don’t have to see whether you do anything naughty,’ so they reduce their monitoring, and this is also a factor why these banks increase their risk taking.”

Jayasuriya also found banks chose to hoard money guaranteed by governments to save in case of future financial emergencies, rather than to lend it.

Despite the challenges related to bank guarantees, Jayasuriya said the bank bailouts in countries such as the U.S., the U.K. and Australia in the wake of the global financial crisis in 2008 constituted the right response.

“All these banks were big banks, and if they failed, a lot of households, weak households and companies would have lost money,” she said. “The key thing is to closely monitor these banks and to avoid these banks risking investments.”

ABC News described the study as the first of its kind to analyze raw data on government guarantees provided by financial authorities.