Do Repeated Government Infusions Help Financial Stability? Evidence from an Emerging Market

Speaker:

Madhu Kalimipalli, Ph.D., Professor of Finance, Wilfrid Laurier University

Moderator:

Eshwar Venugopal, Ph.D., Assistant Professor, Department of Finance, UCF

We study the possible effect of government infusions on promoting financial stability and diffusing financial crises in emerging markets. While government led bank capital infusions in US and other developed markets have been usually contingent an external shock or crisis episode, India presents a unique setting where significant capital infusions happen regularly “annually” to stabilize the weak balance sheets of the public sector banks. Such repeated capital infusions can either better engender financial stability, given the timely government interventions; or create instability arising from possible moral hazard concerns. "Do such repeated government sponsored bank capital infusions lower the financial risks and improve the financial stability?” We shed light on the question through the lens of capital infusions in an emerging market. Based on the exhaustive sample of capital infusions by Government of India into the government controlled public sector banks for the period 2008-18, we find robust evidence that capital infusions increase default and systemic risks for the banks. Capital infusions are associated with significantly higher capital shortfall and network risks, signaling a moral hazard problem where treatment banks may assume more risky investments. Our difference-in-difference regression results are robust to a battery of tests including alternate risk measures, control samples, endogeneity tests, and sample periods. To the best of our knowledge, this study contributes to the literature by providing the first comprehensive study of how repeated government capital infusions impact financial stability in the context of an emerging market. 

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