How do Banks use Bailout Money? Optimal Capital Structure, New Equity, and the TARP

Between October 28, 2008 and June 30, 2009 over six hundred banks and bank holding companies accepted money from the United States government in exchange for preferred shares and warrants. Based on a matched sample of banks participating and not participating in this Capital Purchase Program (CPP), of each dollar of new government equity, on average participants levered roughly thirteen cents to support increased lending while they used roughly sixty cents to increase their regulatory capital ratios. Over the last business cycle, 2000-2008, allocation of new capital to support lending was higher than in 2008-2009 by nearly thirty cents per dollar of new capital. Moreover, in the last downturn, 2000-2001, allocation to new lending was higher by an even greater amount. Banks' exposure to past-due loans, which was higher in 2008 than in 2000 or in any other sample year, negatively predicts allocation of new capital to new lending. Characteristics of CPP participants suggest they were of two types: those with high commitments and opportunities for new lending, and those with exposures to certain troubled loan classes. Banks with high leverage and high expected costs of regulatory downgrades also were more likely participants. All of these results are consistent with banks having an optimal, target capital structure based on some form of tradeoff theory