Stealing Deposits: Deposit Insurance,Risk‐Taking,and the Removal of Market Discipline in Early 20th‐Century Banks

Deposit insurance reduces liquidity risk but can increase insolvency risk by encouraging reckless behavior. Several U.S. states installed deposit insurance laws before the creation of the Federal Deposit Insurance Corporation, and those laws applied only to some depository institutions within those states. These experiments present a unique testing ground for investigating the effect of deposit insurance. We show that deposit insurance removed market discipline constraining uninsured banks. Taking advantage of World War I's rise in world agricultural prices, insured banks increased their insolvency risk and competed aggressively for deposits. When prices fell after the war, the insurance systems collapsed and suffered high losses.     

Structural effects of asset-backed securitization

This paper analyses the potential changes in the operational structure of deposit-taking financial institutions that securitize assets. Findings indicate that banks can create an asset securitization pipeline structure that enables them to increase their return on capital. In other words, through securitization banks can expand their loan provision business without increasing their liabilities or their capital levels. Using a contingent claims model, four factors that impact on the bank's decision to securitize are highlighted and analysed: (i) the level of deposit insurance; (ii) capital adequacy requirements; (iii) insolvency risk; and, (iv) the risk of credit enhancements. Furthermore, we identify key accounting and regulatory challenges that emerge for banks from the process of asset backed securitization.     

Optimal Bank Reorganization Policies and the Pricing of Federal Deposit Insurance

Optimal dynamic regulatory policies for closing ailing banks and for deposit insurance premia are derived as functions of the rate of flow of bank deposits, and interest rate on deposits, the economy's risk-free interest rate, and the regulators' bank audit/administration costs. Under competitive conditions, the threshold assets-to-deposits ratio below which a bank should be optimally closed is shown to be greater than or equal to one. Optimal deposit insurance premia and probabilities of bank closure are shown to be nondecreasing in the bank's risk on investment and nonincreasing in the bank's current assets-to-deposits ratio.     

Regulatory Incentives and the Thrift Crisis: Dividends,Mutual-to-Stock Conversions,and Financial Distress

During the 1980s, insolvency of individual thrifts and the thrift deposit insurer created severe incentive problems. Lacking cash to close insolvent thrifts, regulators induced nearly $10 billion of private capital to flow into the industry through mutual-to-stock conversions. We test a theory of how regulators encouraged capital-impaired mutual thrifts to convert by permitting them to pay dividends rather than rebuild capital. We estimate the costs of this policy and interpret the 1991 Federal Deposit Insurance Corporation Improvement Act as requiring regulators to impose restraints on depository institutions parallel to debt covenants that prevent capital distributions by nonfinancial firms experiencing distress.     

Do some lenders have information advantages? Evidence from Japanese credit market data

Using detailed Japanese credit data, we test for the existence of a credit market hierarchy. Empirical tests indicate that firms with information problems are more likely to carry higher proportions of relationship loans from main banks than non-main banks, holding constant risk and control factors. We further examine credit specialization on the part of lenders by testing the relationship between client firms' information and risk characteristics and the concentration of loans obtained from depository institutions versus other financial institutions. However, no significant differences in information superiority between these two types of financial institutions are found. We conclude that our evidence supports the credit market hierarchy hypothesis for Japanese main banks in particular but not depository institutions in general.     

How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem*

As bank regulatory reform tries to come to grips with the lessons of the financial crisis, several experts have proposed that some form of contingent convertible debt (CoCo) requirement be added to the prudential regulatory toolkit. In this article, the authors show how properly designed CoCos can be used not just to absorb losses, but more importantly to encourage banks to recognize losses and replace lost equity in a timely way, as well as to manage risk more effectively. Their proposed CoCos requirement strengthens management's incentives to promptly replace lost capital and enhance risk management by imposing major costs on the managers and existing shareholders of banks that fail to do so. Key elements of the proposal are that conversion of the CoCos into equity would be (1) triggered at a high trigger ratio of equity to assets (long before the bank is near an insolvency point), (2) determined by a market trigger (using a 90‐day moving average market equity ratio) rather than by supervisory discretion, and (3) significantly dilutive to shareholders. The only clear way for bank managements to avoid such dilution would be to issue equity into the market. Under most circumstances—barring an extremely rapid plunge of a bank's financial condition—management should be able and eager to replace lost capital in a timely way; as a result, dilutive conversions should almost never occur. Banks would face strong incentives to maintain high ratios of true economic capital relative to risky assets, and to manage their risks effectively. This implies that “too‐big‐to‐fail” financial institutions would not be permitted to approach the point of insolvency; they would face strong incentives to recapitalize long before that point. And if they should fail to issue new equity in a timely manner, the CoCos conversion would provide an alternative means of recapitalizing banks well before they reach the brink of insolvency. Thus, a CoCos requirement would go a long way to resolving the “too‐big‐to‐fail” problem. Such a CoCos requirement would not only increase the effectiveness of regulation, but also reduce its cost. It would be less costly for banks to raise CoCos than equity, reflecting both the lower adverseselection costs of CoCos issuance and the potential tax advantages of debt. And precisely because of the low probability of CoCo conversion, the Cocos would be issued at relatively modest (if any) discounts to otherwise comparable but straight subordinated debt. Thus requiring a mix of equity and appropriately designed CoCos would be less costly to banks, and would entail less of a reduction in the supply of loans than would a much higher book equity requirement alone.     

Is Fairly Priced Deposit Insurance Possible?

We analyze risk-sensitive, incentive-compatible deposit insurance in the presence of private information and moral hazard. Without deposit-linked subsidies it is impossible to implement risk-sensitive, incentive-compatible deposit insurance pricing in a competitive, deregulated environment, except when the deposit insurer is the least risk averse agent in the economy. We establish this formally in the context of an insurance scheme in which privately informed depository institutions are offered deposit insurance premia contingent on reported capital; the result holds for alternative sorting instruments as well. This suggests a contradiction between deregulation and fairly priced, risk-sensitive deposit insurance.     

Not all bank systemic risks are alike: Deposit insurance and bank risk revisited

This study investigates how deposit insurance, especially in terms of its design features, affects the sources of banking systemic risk. We do so by decomposing a bank's contribution to systemic risk into idiosyncratic tail risk (Alpha), the exposure to fundamental macroeconomic and finance factors (Beta) and bank interconnectedness (Gamma). Our results indicate that while deposit insurance may increase Alpha, there is a U-shaped relationship between deposit insurance coverage and Beta and Gamma, indicating the existence of an optimal coverage level that minimizes systemic risk. We also find that insurance design characteristics significantly affect the U-shaped relationship. Deposit insurance designed to be independently organized, with public administration, additional supervision and risk minimization functions, and private funding, further reduces the systemic risk associated with any given level of coverage. With several robustness checks, including potential endogeneity, heterogeneity, and possible limits in the sample, the results remain valid. Our results should benefit policymakers who design and optimize deposit insurance schemes to ensure that they play a positive role.     

BANK PRIVATIZATION AND CONVERGENCE OF PERFORMANCE: INTERNATIONAL EVIDENCE

We trace the extent of performance deviation of privatized banks from established private banks in 30 countries from 1994 to 2005 and investigate the role of bank regulatory and supervisory norms, market competition, ownership structure, deposit insurance scheme, and governance structure affecting the deviation. Evidence shows that privatization does improve the performance of banks in the first year of being privatized, but performance gradually declines, which is consistent with the government restructuring argument before the privatization. Governance, foreign ownership, banking freedom (regulations), and the deposit insurance scheme in respective economies are found to affect performance deviation significantly.     

The federal deposit insurance fund that didn't put a bite on U.S. taxpayers

Unlike the Federal Savings and Loan Insurance Corporation and the Bank Insurance Fund, the National Credit Union Share Insurance Fund (NCUSIF) survived the 1980s without falling into a state of accounting insolvency. This paper analyzes how differences in incentive structure constrain the attractiveness of interest-rate speculation and other risk-taking opportunities to managers and regulators of credit unions. Despite these better incentives, robust present-value calculations establish that NCUSIF fell into economic insolvency during the mid-1980s.Besides calculating the extent of this insolvency, the paper also seeks to explain why, after NCUSIF became insolvent, it could rebuild its reserves without an explicit or implicit taxpayer bailout. Our explanation turns on cross-industry coinsurance responsibilities and the shallowness of the fund's observed insolvency relative to industry net worth. We identify forces in the decisionmaking environment tending to limit the depth and duration of unresolved insolvencies at individual credit unions. Managerial opportunities to benefit personally from taking risks that would flow through to NCUSIF are constrained by difficulties in converting a credit union to stockholder form and by the intensity of proactive monitoring of troubled credit unions by sister institutions and other private coinsurers. We conjecture that expanded use of coinsurance and private monitoring could reduce taxpayer loss exposure elsewhere in government deposit insurance systems.     

The Value of Bank Durability: Borrowers as Bank Stakeholders

We examine the value of bank durability to borrowing firms. The analysis is based on theoretical models of the asset services view of intermediation which imply that private information and associated relationship-specific activities are intrinsic to bank lending. We analyze share price effects on firms with lending relationships with Continental Illinois Bank during its de facto failure and subsequent FDIC rescue. We find the bank's impending insolvency had negative effects and the FDIC rescue positive effects on client firm share prices. We conclude that borrowers incur significant costs in response to unanticipated reductions in bank durability and thus are bank stakeholders.     

THE DIFFERENTIAL EFFECTS OF DEREGULATION ON SAVINGS AND LOAN ASSOCIATIONS AND BANKS

The passage of the Garn-St Germain Depository Institutions Act of 1982 was a legislative response to the plight of the thrift industry. The Act broadened the asset/liability powers of thrifts and granted regulators emergency authority to aid failing institutions. In this paper we analyze the effect of the Act on the market returns of large S&Ls and banks using a two-factor estimating procedure. Single-factor models of depository institutions' returns produce biased estimates and confound the Act's interpretation. Explicit treatment of the event/risk interaction is necessary to avoid ambiguities in the interpretation of the Act's effect on the returns of depository institutions. It is difficult to use capital market data to pinpoint the effect of information flows on complex regulatory changes.     

Deposit market competition,wholesale funding,and bank risk

Empirical research on the effect of bank competition on bank risk has so far produced very inconclusive results. In this paper we revisit this long-standing debate and propose a new empirical approach that is concentrated on the relationship between deposit market competition and bank risk. This approach closely follows the traditional theoretical views of the competition and risk relationship and is focused on testing the classical moral hazard problem of the bank: deposit market competition raises the optimal risk choice of the bank by raising the costs of bank liabilities. Since banks can substitute between retail and wholesale funding, we relate deposit market competition to wholesale market conditions and examine their joint effect on the risk of bank assets. The analysis is based on a unique, comprehensive dataset, which combines retail deposit rate data with data on bank characteristics and data on local deposit market features for a sample of 589 US banks. Our results support the notion of a risk-enhancing effect of deposit market competition.     

Assessing the riskiness and profitability of credit-card banks

This article measures the riskiness and profitability of financial institutions specializing in credit-card loans and related plans. Focusing on explicit accounting returns on explicit credit-card assets, we find that credit-card banks, whether subsidiaries of bank holding companies or independent banks, earned extraordinary returns over the years 1984 to 1991. On average, credit-card firms had pretax return on assets of 3.36 percent compared to .95 for noncredit-card banks. The costs of the higher returns are greater variability of ROA and higher probabilities of insolvency, indicating that credit-card banks are riskier than other commercial banks.After a decade of rapid and profitable growth, America's credit-card business is slowing down and turning cut-throat. Card companies must adap to survive.-The Economist, November 2, 1991     

An Incentive Approach to Banking Regulation

We examine the optimal design of a risk-adjusted deposit insurance scheme when the regulator has less information than the bank about the inherent risk of the bank's assets (adverse selection), and when the regulator is unable to monitor the extent to which bank resources are being directed away from normal operations toward activities that lower asset quality (moral hazard). Under a socially optimal insurance scheme: (1) asset quality is below the first-best level, (2) higher-quality banks have larger asset bases and face lower capital adequacy requirements than lower-quality banks, and (3) the probability of failure is equated across banks.     

It takes more than two to tango: Multiple bank lending,asset commonality and risk

Multiple-bank lending is the most prevalent form of bank-firm credit relationships in nearly all countries. It results in high asset commonality and interconnectedness, allows idiosyncratic risks to become systemic, and makes the banking system more fragile and vulnerable to shocks. Using detailed, granular-level, supervisory data on large corporate loans, we show that multiple bank lending is driven, inter alia, by regulatory limits on large credit exposures. These limits, aimed at mitigating an individual bank's concentration risk, force firms to explore alternative sources of funding, making the common borrowers' phenomenon more prominent. We find that multiple bank lending is determined endogenously, and its likelihood increases with the level of portfolio similarity between lenders. The size of the original lender and its systemic importance magnifies this effect. We argue that banks do not internalize the systemic effect of their lending decisions and that multiple bank lending constitutes an insurance mechanism related to an implicit "too-many-to-fail" guarantee. Its externalities are suboptimal and should be reinforced with better monitoring by the related authorities.     

International evidence on the impact of regulations and supervision on banks’ technical efficiency: an application of two-stage data envelopment analysis

This study uses a sample of 715 banks from 95 countries and two-stage data envelopment analysis (DEA) to provide international evidence on the impact of regulations and supervision approaches on banks’ efficiency. We first use DEA to estimate technical and scale efficiency. We then use Tobit regression to investigate the impact of several regulations related to capital adequacy, private monitoring, banks’ activities, deposit insurance schemes, disciplinary power of the authorities, and entry into banking on banks’ technical efficiency. We estimate several specifications while controlling for bank-specific attributes and country-level characteristics accounting for macroeconomic conditions, financial development, market structure, overall institutional development, and access to banking services. In several cases, the results provide evidence in favour of all three pillars of Basel II that promote the adoption of strict capital adequacy standards, the development of powerful supervisory agencies, and the creation of market disciplining mechanisms. However, only the latter one is significant in all of our specifications. While the remaining regulations do not appear to have a robust impact on efficiency, several other country-specific characteristics are significantly related to efficiency.

The Political Economy of Deposit Insurance

This paper uses a political economy framework to analyze cross-country differences in deposit insurance coverage. It finds supporting evidence of the significance of private interest theories in explaining coverage of deposit insurance. Deposit insurance coverage is significantly higher in countries where poorly capitalized banks dominate the market and in countries where depositors are poorly educated. The analysis does not find that coverage is significantly related to political-institutional variables, such as the degree of democracy or restraints on the executive, or to proxies for the general level of institutional development, such as per capita income or property rights. These results provide evidence in support of the private interest view, according to which risky banks lobby for extensive coverage.     

Bank governance,regulation and risk taking

This paper conducts the first empirical assessment of theories concerning risk taking by banks, their ownership structures, and national bank regulations. We focus on conflicts between bank managers and owners over risk, and we show that bank risk taking varies positively with the comparative power of shareholders within the corporate governance structure of each bank. Moreover, we show that the relation between bank risk and capital regulations, deposit insurance policies, and restrictions on bank activities depends critically on each bank's ownership structure, such that the actual sign of the marginal effect of regulation on risk varies with ownership concentration. These findings show that the same regulation has different effects on bank risk taking depending on the bank's corporate governance structure.     

How bank capital buffers vary across countries: The influence of cost of deposits,market power and bank regulation

This paper analyzes the bank and country determinants of capital buffers using a panel data of 1337 banks in 70 countries between 1992 and 2002. After controlling for adjustment costs and the endogeneity of explanatory variables, the results show that capital buffers are positively related to the cost of deposits and bank market power, although the relations vary across countries depending on regulation, supervision, and institutions. Their impact is the result of two generally opposing effects: restrictions on bank activities and official supervision reduce the incentives to hold capital buffers by weakening market discipline, but at the same time they promote higher capital buffers by increasing market power. Institutional quality has the two opposite effects. Better accounting disclosure and less generous deposit insurance, however, have a clear positive effect on capital buffers by both strengthening market discipline and making charter value better able to reduce risk-taking incentives.