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.