To give is to take: The effects of government deposits on bank risks

As government and financial sector funds become increasingly intertwined, managing the influence of government deposits on the financial system has become an important way for preventing the escalation of bank risks. Using data of China’s city commercial banks from 2009 to 2017, we provide the first empirical test of the risk effects of government deposits and their transmission channels by employing a fixed-effects model and an instrumental variable approach. Our findings reveal that government deposits exert discernible credit allocation effects that exacerbate banks’ risks. Specifically, the risk exacerbation effects are shaped by credit expansion, policy-orientated loan, and credit term structure. By using a panel threshold model, we find that the impact of government deposits on bank risks exhibits clear threshold effects depending on banks’ equity assets and market environment. Furthermore, government deposits also influence banks’ revenue, and are impacted by the pace of government expenditure. Our paper sheds new light on the relationship between government and financial system in a broader context.