Study finds government guarantees lead banks to taking more risks with lending

The global financial crisis prompted governments around the world to guarantee their country's banks to protect against collapse.

But a new study of more than 2,200 banks around the world showed that rather than prompt lending, government guarantees encouraged banks to take more risks.

In yet to be published research, Dulani Jayasuriya, a Phd candidate in finance at the National University of Singapore obtained data from central banks and financial authorities in 78 countries spanning from 2001 to 2011.

Ms Jayasuriya found that instead of lending more money because the banks were effectively underwritten by the government, the banks took more risks.

"The surprising find is usually when you give money to these banks you expect them to reduce their risk.

"But what they actually do is they increase their risk taking and they reduce their lending," Ms Jayasuriya told the ABC.

The study found that private and state banks with a government guarantee lent less money while foreign banks lent more.

In response to the financial meltdown, many governments guaranteed bank deposits or directly bailed out banks including in the United States, United Kingdom and Australia.

Ms Jayasuriya said banks tended to hold onto the cash they got from government to protect against future losses.

She said her study found that government guarantees for banks increased moral hazard especially for "too big to fail" banks - banks considered crucial to the stability of a banking system.

"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," Ms Jayasuriya 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."

Bailing out 'too big to fail' banks the right move: study

Ms Jayasuriya said the timing and type of government guarantee was also important and the measures also needed to be country and region specific.

"Timing is important, when you give the government guarantee to these banks and the type of government guarantee," she said.

"Do you outright hand them out money like in liquidity support? Do you give them blanket guarantees? That is basically saying 'we guarantee all your deposits', so the depositors are safe."

The flip side was that deposit guarantees also encouraged customers not to monitor a bank's risk taking because the mechanism made them feel like their money was safe.

Despite the challenges raised by bank guarantees, Ms Jayasuriya said it was the right response to contain the global financial crisis.

"All these banks were big banks and if they failed, a lot of households, weak households and companies would have lost money.

"The key thing is to closely monitor these banks and to avoid these banks risking investments," Ms Jayasuriya.

Australian banks fare well compared to international counterparts

Ms Jayasuriya said that "too big to fail" banks needed higher capital reserves to protect them against loan losses, a key recommendation of Australia's Financial System Inquiry.

"All these big, naughty banks they live an international life but they die a national death like the former governor of the Bank of England, Sir Mervyn King, said.

"They might do naughty things outside in other countries but the local depositors and the local government have to bail them out in the end."

However, she said Australian banks fared well in the study.

The study is the first research of its kind to collect and analyse raw data on government guarantees from financial authorities.

"As everybody knows during the crisis a lot of these big, naughty banks spent a lot of money and then they had to be bailed out by the government.

"So it's very important to see what they did after they got this money," she said.

Ms Jayasuriya presented her research at a financial conference in Sydney last week organised by the Institute for Global Finance at the University of New South Wales.