Do Bank Bailouts Reduce or Increase Systemic Risk? The Effects of TARP on Financial System Stability
Theory suggests that bank bailouts may either reduce or increase systemic risk. This paper is the first to address this issue empirically, analyzing the U.S. Troubled Assets Relief Program (TARP). Difference-in-difference analysis suggests that TARP significantly reduced contributions to systemic risk, particularly for larger and safer banks located in better local economies. This occurred primarily through a capital cushion channel. Results are robust to additional tests, including accounting for potential endogeneity and selection bias. Findings yield policy conclusions about the wisdom of bailouts, which banks might be the best targets for future bailouts, and the form these bailouts might take.