TARP’S EFFECT ON BANKS' REPORTED PERFORMANCE An empirical study on TARP contributions’ relative sizes’ effect on bank performance Master’s Thesis

The financial crisis that began in August 2007 has been the most significant challenge to the banking industry and financial system as a whole in the U.S. since the great recession in the 1930s. It is one of the most studied series of events in the modern economic research. Government intervention is a controversial measure taken to mitigate the widespread negative effects resultant form a banking crisis. This thesis studies the U.S. Treasury’s Troubled Asset Relief Program’s (“TARP”) effect on the banks’ performance by the means of a review of earlier literature on the subject and by conducting an empirical study. The empirical study uses accounting-based profitability and balance sheet based indicators in determining the performance of the banks. Three regression models are estimated in the empirical study. The models are formulated to answer the research question “Were the TARP funds allocated optimally and fairly among the U.S. banking industry’s entities?” by studying the TARP funds’ size’s – relative to the recipients’ total assets – effect on the banks’ performance one year after the TARP capital injections. Earlier literature has found that TARP e.g. worsened the operating efficiency of the banks participating in it, but allowed competitive advantages, and an increase in market share and market power for its recipients. Earlier literature has also concluded that TARP induced moral hazard among banks. The results of the empirical study conducted in this thesis suggest that the relative size of received TARP funds has had an effect on the banks’ performance one year after the TARP injections. The relative size of received TARP funds has had a clear positive effect on return on loans. However, the effect on other performance indicators is mixed. The profitability indicators subject to the most managerial discretion in terms of result management have been affected negatively by the relative size of received TARP funds, which could indicate that the receipt of a large TARP injection has encouraged managers to unravel already accumulated writedown backlogs. The results of the empirical study also find that banks’ prior performance has had an effect on the banks’ probability to receive TARP funds: more poorly performing banks were more likely to receive TARP funds. The possibility of the TARP funds affecting the bank managers’ usage of discretionary items opens an interesting possibility for accounting research to further study the phenomenon. The results of this study call for research on the usage of discretionary items before, during, and after TARP in U.S. banks, and the relative TARP funds’ size’s effect on these.