Theory suggests that government aid to banks may either reduce or increase systemic risk. We are the first to address this issue empirically, analyzing the Troubled Assets Relief Program (TARP). Analysis suggests that TARP significantly reduced contributions to systemic risk, particularly for larger and safer banks, and those in better local economies. This occurred primarily through a capital cushion channel that reduced market leverage by increasing the value of common equity. Results are robust to endogeneity and selection bias checks. Findings yield policy conclusions about whether to aid banks, the best targets for future assistance, and short-term versus long-term effects.

We review research on the effects of banks on the real economy, including, but not limited to articles in this Special Issue of the Journal of Corporate Finance. We focus primarily on US and European policy interventions that provide quasi-natural experiments with relatively exogenous shocks to bank output. We concentrate on single-country settings, avoiding potentially confounding differences in language, culture, law, currency, and so on, that complicate cross-country investigations. We also largely avoid the effects of financial crises, which are not exogenous to the banking system. The evidence strongly suggests positive effects of banks on the real economy.

A key issue in the finance-growth nexus literature is endogeneity – economic growth may drive finance as well as finance driving growth. Some research addresses endogeneity using relatively exogenous shocks from U.S. bank geographic deregulation, often documenting favorable economic effects. We connect deregulation shocks for the first time to individual firm growth in a model that differentiates sources of external financing – short-term debt, long-term debt, and equity. Our results suggest that deregulation increases firm growth overall and this growth is fueled by all three external funding sources. However, benefits accrue only to relatively financially unconstrained firms, while relatively constrained firms lose.