In 2001, government guarantees for savings banks in Germany were removed
following a lawsuit. We use this natural experiment to examine the effect of government
guarantees on bank risk-taking. The results suggest that banks whose government guarantee
was removed reduced credit risk by cutting off the riskiest borrowers from credit. Using a
difference-in-differences approach we show that none of these effects are present in a
control group of German banks to whom the guarantee was not applicable.
Furthermore, savings banks adjusted their liabilities away from risk-sensitive debt instruments
after the removal of the guarantee, while we do not observe this for the control
group. We also document that yield spreads of savings banks' bonds increased significantly
right after the announcement of the decision to remove guarantees, while the yield spread of
a sample of bonds issued by the control group remained unchanged. The evidence implies
that public guarantees may be associated with substantial moral hazard effects.
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