Paul. Banks have always wanted to signal that they are high quality – even when they weren’t. As a result, the signal wasn’t credible.

Hence, in the event of a big shock to banking system confidence we can get an inefficient bank run. The TARP was designed to prevent this type of bank run, and as a result was made universal so as to prevent funds shifting from banks that were normally in good health but would have needed TARP funds temporarily (as opposed to banks that were just in straight trouble).

Now that the banking crisis has abated, they are letting the market use the TARP as a signal – as that way we can ensure that the worst banks still have to shut down, the medium banks will operate, and the best banks get rewarded. This isn’t a sign that government policy was wrong – it is a sign that policy was flexible and appropriate, a surprising result but a good one.

So with TARP they prevented bank failures, and then allowed the best banks to have a credible signal of quality – man it just sounds like a better and better policy by the day 😀

The implementation of TARP allowed for a separating equilibrium, which would have risked a run on banks that chose to take government money to prop up their balance sheets. Since banks would have risked destruction by initially taking the money, yet the money was needed to reinforce the banking system, it made sense to enforce a pooling equilibrium and prevent the use of TARP as a signal.

Now that the hysteria has died down there isn’t the same risk of a run on banks involved in TARP. That means that the government has been able to relax its position on using TARP as a signalling device and a separating equilibrium may be forming.

To suggest that TARP was implemented to prevent signalling misunderstands the counterfactual situation. Without TARP there was no credible signal of quality, which is why the banks needed the support in the first place.

Indeed, but the choice about whether to take the TARP will differ based on the health of the banks – allowing a separating equilibrium of the sort that we now seem to be observing!

Even the unhealthy banks have an incentive to say they are healthy. Without the TARP there is no seperating equilibrium since both “types” have the incentive to say the same thing.

And not only that, the government made money off it.