TARP announcement, bank health, and borrowers’ credit risk

• Theory suggests that a bank's financial health may influence the capacity of TARP capital infusions to ease the liquidity constraints and, hence, reduce the credit risk of borrowers.
• This paper investigates how the financial health of leading TARP recipient banks influenced their borrowers’ credit risk measured by credit default swap (CDS) spreads.
• Following the announcement of TARP, vulnerable borrowers of unhealthy banks experienced a less reduction in credit risk relative to those of healthy banks.
• The findings suggest that the CDS market anticipated unhealthy banks, relative to healthy banks, to provide less liquidity relief to their vulnerable borrowers, consistent with a more pronounced flight-to-quality behavior.

Theory suggests that unhealthy banks exhibit more pronounced flight-to-quality behavior during financial crises and, hence, the infusion of capital through unhealthy banks is less effective in relieving the liquidity shocks of vulnerable borrowers. We test these predictions by investigating how the financial health of leading US banks influenced their borrowers’ credit risk surrounding the announcement of the Troubled Asset Relief Program (TARP). Changes in borrower credit risk, measured by credit default swap (CDS) spreads, should reflect the expected relief from liquidity shocks and other benefits of rescuing banks, such as maintaining the existing lending relationships. Consistent with the theory, prior to the TARP capital infusions, unhealthy banks’ borrowers with high leverage experienced a greater increase in their credit risk relative to similar healthy banks’ borrowers. Following the event, the CDS market anticipated less liquidity relief to these vulnerable unhealthy banks’ borrowers, but more liquidity relief to the vulnerable healthy banks’ borrowers.