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Government Guarantees and Bank Risk Taking Incentives
Report

Government Guarantees and Bank Risk Taking Incentives

Markus Fischer, Christa Hainz, Jörg Rocholl and Sascha Steffen
CESifo Group Munich, 2014
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Editorial Rating

7

Qualities

  • Analytical
  • Innovative
  • Eye Opening

Recommendation

As central bankers and government officials consider removing the explicit and implicit financial guarantees they established in the heat of fiscal crises, Germany’s early 2000s experience with its Landesbanken offers some significant lessons. These state-owned banks subsequently had an outsized role in building the global asset-backed securities bubble that burst in 2008. getAbstract recommends this perceptive analysis from the Center for Economic Studies & Ifo Institute for the light it sheds on the unintended consequences of ending government guarantees.

Take-Aways

  • Without state support, a bank experiences a higher cost of capital and lower overall profitability. That drop in its “franchise value” – “the present value of future profits” – spurs risk taking to shore up returns.
  • But shareholders and creditors closely monitor nonguaranteed banks to protect their investments. Under this “market discipline,” a bank will rein in its risk.
  • In July 2001, German officials announced the withdrawal of state guarantees for the Landesbanken , but the guarantees would remain in effect until July 2005.

About the Authors

Markus Fischer teaches business administration at Goethe University Frankfurt. Christa Hainz is a senior economist at the Ifo Institute. Jörg Rocholl is the president of the European School of Management and Technology in Berlin, where Sascha Steffen is an associate professor.

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