WORKING PAPER SERIES NO. 302 / FEBRUARY 2004 DEPOSIT INSURANCE, MORAL HAZARD AND MARKET MONITORING by Rent Gropp and Jukka Vesala
WORKING PAPER SERIES NO. 302 / FEBRUARY 2004 DEPOSIT INSURANCE, MORAL HAZARD AND MARKET MONITORING 1 by Rent Gropp 2 and Jukka Vesala In 2004 all publcatons wll feature a motf taken from the 100 banknote. Ths paper can be downloaded wthout charge from http://www.ecb.nt or from the Socal Scence Research Network electronc lbrary at http://ssrn.com/abstract_d=515064. 1 Research assstance by Sandrne Corvoser and Andres Manzanares s gratefully acknowledged. All errors are the authors. The vews expressed n ths paper are solely those of the authors and not those of the or the Eurosystem. We are grateful for the comments receved from Charles Calomrs, Asl Demrguc-Kunt, Xaver Frexas, Vtor Gaspar, Hans Gersbach, Phlpp Hartmann, Martn Hellwg, Anl Kashyap, Davd Mayes, Benot Mojon, Mtchell Petersen, Jean-Charles Rochet, two anonymous referees, semnar partcpants at the, the 2nd Kel Workshop n Economcs The Integraton of Fnancal Markets n Europe, the IFS/Wharton Conference Competton among Banks: Good or Bad?, the CEPR/EER/IAE Conference on Fnance n Manresa/Span, the Federal Reserve Bank of Chcago 38th Annual Conference on Bank Structure and Competton and the IMF. 2 European Central Bank, Kaserstraße 29, D-60311 Frankfurt am Man, Germany. Correspondng authors emal adress: rent.gropp@ecb.nt.
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CONTENTS Abstract 4 Non-techncal summary 5 I. Introducton 6 II. A stylsed model of the safety net and moral hazard 7 III. Insttutonal background 15 IV. Data sources and descrpton 16 V. Defntons of dependent and ndependent varables 17 VI. Econometrc model and baselne results 20 VII. Banks balance sheet structure 25 VIII. Robustness 26 IX. Concluson 27 Lterature 29 Tables 31 Appendces 37 European Central Bank workng paper seres 42 Workng Paper Seres No. 302 3
Abstract The paper analyses the relatonshp between depost nsurance, debt-holder montorng, and rsk takng. In a stylsed bankng model we show that depost nsurance may reduce moral hazard, f depost nsurance credbly leaves out non-depost credtors. Testng the model usng EU bank level data yelds evdence consstent wth the model, suggestng that explct depost nsurance may serve as a commtment devce to lmt the safety net and permt montorng by unnsured subordnated debt holders. We further fnd that credble lmts to the safety net reduce rsk takng of smaller banks wth low charter values and szeable subordnated debt shares only. However, we also fnd that the ntroducton of explct depost nsurance tends to ncrease the share of nsured deposts n banks labltes. JEL classfcaton: G21, G28 Key words: Bankng, Moral Hazard, Market Montorng, Depost Insurance 4 Workng Paper Seres No. 302
Non-techncal summary Markets can lmt the rsk takng of banks, only f some market partcpants unambguously have ther money at stake. Ths mples that some labltes of the bank must be credbly excluded from the safety net. In ths paper, we argue that explct depost nsurance may play a useful role as a commtment devce of authortes to lmt the safety net to those explctly covered under the depost nsurance. Ths pont stands n contrast to the frequently reterated argument that depost nsurance generates moral hazard and ncentves for excessve rsk takng by banks. If pror to the ntroducton of depost nsurance mplct guarantees were broad, the effect of ntroducng explct depost nsurance on market montorng and rsk takng of banks may be postve. The reason s that all credtors of the bank asde from those nsured under the explct system may have stronger ncentves to montor the bank. Based on the emprcal evdence for the European Unon (EU) presented n ths paper, t appears that explct depost nsurance may n fact be a useful way to lmt the safety net, ncrease market montorng of banks, and reduce moral hazard. In ths paper, we frst present a smple model whch suggests that proft maxmsng banks may ncrease or reduce ther rsk takng n response to the ntroducton of depost nsurance, dependng on four factors. One, whether or not the explct depost nsurance s credble n excludng all other credtors of the bank. Second, the charter value of the bank. Thrd, the share of labltes asde from nsured deposts on the balance sheet of the bank. And fourth, whether or not the banks s too-bg-to-fal. The model hghlghts that the ntroducton of explct depost nsurance, whch credbly mposes lmts on the safety net, wll result n a reducton of rsk for banks wth low charter values, hgh shares of non-nsured labltes and for banks that are not too-bg-to-fal. The predctons of the model are tested n a sample of EU banks durng the 1990s. The EU n the 1990s s a partcularly sutable envronment for testng the model, because a number of countres ntroduced explct depost nsurance durng that perod. Ths mples that there s cross-sectonal as well as tme seres varaton n the exstence of explct depost nsurance n a sample of banks, whch asde from depost nsurance operate n a largely smlar regulatory envronment. The emprcal results are broadly consstent wth the theory. In partcular we fnd: () The ntroducton of explct depost nsurance n the EU may have sgnfcantly reduced banks rsk takng. () Ths effect s stronger for banks wth low charter values and hgh subordnated debt shares. () The rsk takng of banks wth a very large share n the bankng system of the country s unaffected ( too bg to fal ). The theoretcal model also predcts that banks wll ncrease the share of nsured deposts n response to the ntroducton of explct depost nsurance, precsely n order to avod ncreased market dscplne. In depost share regressons, we fnd evdence n favour of ths hypothess. The results of the paper hghlght the mportance of the nsttutonal envronment for effectve market dscplne of banks. It also provdes evdence that banks n fact change ther behavour n response to sgnals from the market,.e. that market dscplne can be effectve. In ths sense, the paper contrbutes to the ongong and extensve debate about the role markets as complements (or even substtutes) for supervsory revew and captal requrements, as outlned n the proposals regardng the reform of the Basel Accord. Workng Paper Seres No. 302 5
I. Introducton Markets can lmt the rsk takng of banks, only f some market partcpants unambguously have ther money at stake. Ths mples that some labltes of the bank must be credbly excluded from the safety net. In ths paper, we argue that explct depost nsurance may play a useful role as a commtment devce of authortes to lmt the safety net to those explctly covered under the depost nsurance. Ths pont stands n contrast to the frequently reterated argument that depost nsurance generates moral hazard and ncentves for excessve rsk takng by banks. If pror to the ntroducton of depost nsurance mplct guarantees were broad, the effect of ntroducng explct depost nsurance on market montorng and rsk takng of banks may be postve. 2 Based on the emprcal evdence for the European Unon (EU) presented n ths paper, t appears that explct depost nsurance may n fact be a useful way to lmt the safety net, ncrease market montorng of banks, and reduce moral hazard. Prevous emprcal evdence concernng the mpact of depost nsurance on bank rsk takng and the potental for bankng sector fraglty s mxed. For example, Wheelock and Wlson [1994] and Alston et al. [1994] fal to establsh a relatonshp between hstorcal US bank falure rates and depost nsurance. In addton, Karels and McClatchey [1999] fal to fnd evdence that the adopton of depost nsurance ncreased the rsk takng of US credt unons. Conversely, Grossman [1992], Wheelok [1992] and Thes and Gerlowsk [1989] fnd a postve and sgnfcant relatonshp. Smlarly, 'HPLUJ o XQW and Detragache [2002] n a sample of 61 countres fnd that over a perod from 1980-97 depost nsurance sgnfcantly ncreased the probablty of a bankng crss n the country. The mpact of depost nsurance on rsk takng nteracts wth at least three other mportant factors: banks charter values, the effectveness of montorng by non-depost credtors and too-bg-to-fal. The falure to accurately reflect any one of these factors may account for the mxed fndngs of the emprcal lterature. If banks are able to earn rents, ether through regulatory lmts on competton (e.g. Keeley [1990]) or valuable lendng relatons (Sharpe [1990] and Rajan [1992]) or the acquston of reputaton (e.g. Boot and Greenbaum [1992]), the effects of depost nsurance on rsk takng may be mtgated. Smlarly, the degree of rsk takng of banks may be nfluenced by the amount of unnsured debt banks carry on ther balance sheets (Dewatrpont and Trole [1993a]) 2 The ample nterventon by the government durng the Swedsh and Fnnsh bankng crses n the early 1990, where explct and lmted depost nsurance systems were not n place beforehand, can be taken as supportng evdence n favour of the latter contenton. 6 Workng Paper Seres No. 302
and Calomrs [1999]). And thrd, f banks are perceved as too-bg-to-fal, ther rsk takng mght not be affected by the depost nsurance arrangement, as they enjoy a comprehensve safety net n any case. Ths paper ams to extend the emprcal lterature n two man ways. Frst, the exstng emprcal evdence regardng banks rsk takng tends to use U.S. data or use rather heterogeneous samples contanng developng and developed countres, whose bankng systems may be at wdely dfferent stages of lberalsaton and sophstcaton. There s lmted evdence for developed countres, concernng the mpact of depost nsurance arrangements on rsk takng n an envronment of compettve bankng outsde the US. Ths paper attempts to fll part of ths vod. Second, our data set allows us to test a rch set of hypotheses regardng the nteracton between depost nsurance, charter values, montorng, too-bg-to-fal and moral hazard, closng some of the gap between the theoretcal and emprcal lteratures. Our man fndngs can be summarsed as follows: () We fnd evdence that the ntroducton of explct depost nsurance n the EU may have sgnfcantly reduced banks rsk takng. () We fnd that ths effect s less prevalent for banks wth hgh charter values and low subordnated debt shares. () We further fnd that the rsk takng of banks wth a very large share n the bankng system s unaffected ( too bg to fal ). (v) We fnd some adjustments n the balance sheet structure of banks towards more nsured deposts after the ntroducton of explct depost nsurance. The remander of the paper s organsed as follows. In Secton II we motvate our emprcal hypotheses by drawng on a smple model of banks wth moral hazard. In Secton III, we provde some nsttutonal background of depost nsurance and deregulaton n the EU. In Secton IV we descrbe the data set we employ, along wth some summary statstcs. Varable defntons, the emprcal specfcaton and baselne results are reported n Sectons V and VI, respectvely. In Secton VII, we examne the effects of the ntroducton of explct depost nsurance on banks balance sheets. Secton VIII examnes the robustness of our results and Secton IX concludes the paper. II. A stylsed model of the safety net and moral hazard The theoretcal lterature (e.g. Frexas and Rochet [1997], Boot and Greenbaum [1993], Dewatrpont and Trole [1993a, 1993b] and Matutes and Vves [1995]) s unambguous n that the publc safety net, provdng assstance to banks n dstress and protectng banks clam-holders from losses, ncreases the propensty by bank managers to Workng Paper Seres No. 302 7
take on excessve rsk (moral hazard). 3 Ths s so, snce nsured clam-holders of the bank do not have approprate ncentves to montor the actons by banks management. In ths secton, we present a smple model of banks, whch permts a dervaton of condtons under whch the ntroducton of explct depost nsurance results n an ncrease n market montorng f compared wth an mplct bank safety net. The model also allows us to state a number of emprcal hypotheses regardng the nteracton of specfc bank characterstcs and rsk takng under dfferent safety net arrangements. As we wll see below, the model reles heavly on the dea that banks rsk takng may largely be a functon of the presence of a set of credtors, whch are credbly excluded from the safety net. Consder the followng smple, one perod bankng model wth I rsk neutral banks denoted by subscrpt. The banks are fnanced wth deposts and subordnated debt. 4 In order to focus on the effects of the safety net, we abstract from moral hazard related to lmted lablty and conflcts of nterest between dfferent clamants of the bank. The assocated return the bank pays on these two types of labltes are r D and r B, respectvely. The bank nvests n a rsky portfolo of loans and charges a rate of ( r L 1) on those loans. Banks offer a dfferentated loan product, and are prce takers n the depost and subordnated debt markets. For smplcty, we normalse the length of each bank s balance sheet to unty. As n Boot and Greenbaum [1993], the probablty structure of bank s pay-off from ts loan portfolo s (1) 0 wth probablty (1 m ) and L (2) r ZLWKSUREDELOLW\± ) + m. where s the probablty of default n bank s loan portfolo n the absence of montorng and m represents the bank s choce of montorng effort, where m (0,1) and ρ (0,1). The pay-off s a functon of the exogenous default probablty, and the endogenous choce of the bank of how much montorng effort to expend, m. 5 Note that f the bank montors fully,.e. m =1, the bank wll receve r L wth certanty and wll never default. Montorng, however, s costly and we assume a strctly postve and convex montorng cost schedule V(m) wth V (m)>0, V (m)>0, and V(m=0)=0. 3 The safety net, defned as the protecton of banks credtors aganst losses resultng from bank falures, s motvated n the frst place by the short maturty structure of bank labltes and the prvate nformaton characterstc of ther longer-maturty assets, reflectng banks unque lqudty creaton and ntermedaton functons (Damond and Dybvg [1983], Gorton and Pennacch [1990] and Calomrs and Kahn [1991]) 4 For smplcty we assume that banks do not have any equty. Ths assumpton s relaxed subsequently n the dscusson on charter values. 5 The poston of the busness cycle of the economy a bank operates n would be one way to nterpret the exogenous rskness of the portfolo or rskness of the sector that the bank prmarly lends to. 8 Workng Paper Seres No. 302
The bank operates for a successon of equvalent perods untl t fals, where falure s defned as the case of a pay-off to the loan portfolo of zero. To save notaton we suppress subscrpts t. Further, assume that D represents the probablty that the government compensates depostors and B the probablty of government compensaton of subordnated (non-depost) debt n case the bank fals. Hence, f the banks succeeds, depostors and subordnated debt holders receve r D and r B, respectvely. If the bank D fals, they receve D B γ r and γ B r. We specfy the followng no arbtrage relatonshp between montorng, m, the probablty of bal out, B and r L and the rsk free rate, r: B B L (3) r = r + ( 1 m )(1 γ )( r r) and Expresson (3) mples that B B B B r ( γ = 1, m {0,1}) = r ( γ {0,1}, m = 1) = r B B r = 0, m = 0) = (γ r. L Hence, f the bank does not montor and the probablty of a bal out s zero, the borrowng rate wll be equal to the lendng rate. Further, expresson (3) shows that f ether there s complete montorng or the probablty of a bal out s 1, r B wll converge to the rsk free rate, as n that case the bank s portfolo entals zero rsk. Equvalently, for the rate on deposts we have D D L (4) r = r + ( 1 m )(1 γ )( r r ) Hence, the nterest rate on subordnated debt and deposts s the same, as long as they are baled out wth the same probablty. Once ths probablty dffers, the bank wll pay dfferent nterest rates on the two types of labltes. Whle we do not model the preferences of nvestors explctly, equatons (3) and (4) suggest that they are rsk-averse. The rsk premum nvestors expect would be ( r L r), f they nvested n the rsky asset drectly (no montorng). Further, ths rsk premum s lnear and declnng n the bal out probablty and n the level of montorng of the bank. Denotng the share of deposts n bank s labltes wth, each bank maxmses profts of the form π = Solvng L D D B B (( ρ ) + m ρ ) r V( m ) r ( m, γ ) α r ( m, γ )(1 α ). 1 (5) maxπ m yelds the followng frst-order condton: Workng Paper Seres No. 302 9
π m = ρ r L ( ) V m m D B r r α (1 α ) 0. m m Assumng the montorng cost functon has the specfc form of 6 (6) ( ) β V m = ZKHUH! m and substtutng expressons (3) and (4), we obtan the optmal level of montorng * L D L B L (7) m = [ ρ r + α (1 γ )( r r ) + (1 α )(1 γ )( r r )] 1 β From (7) we see that the optmal level of montorng s an ncreasng functon of bank s portfolo rskness, and the nterest rate spread between rsky loans and the rsk free rate. If the portfolo s rsker and the relatve pay-off to rsk greater, the bank wll montor more. In contrast, hgher probabltes of bal out for ether deposts or subordnated debt wll reduce the bank s level of montorng. Note also, that n case deposts and subordnated debt are baled out by the government wth dfferent probabltes, the proporton of the bank that s fnanced wth subordnated debt wll matter. For the moment, we assume that s are fxed, but we wll return to ths ssue below. In the followng we analyse a number of specfc cases. Free bankng 1 β 1 If there s no chance of a bal out or any mplct or explct depost nsurance, we have D = B =0. The frst thng to notce s that n ths case the share of deposts n the labltes of the bank,, does not matter, as both bank labltes are equally rsky. Hence, the optmal level of montorng becomes 1 1 β 1. * FB L L (8) m = [ ρr + ( r r )] β Note that even n the free bankng case the bank wll not necessarly fully montor and reduce the probablty of falure to zero. We can now calculate the default probablty of bank, p, by substtutng equaton (8) nto (1) 1 β 1. FB (9) 1 L L p = ρ 1 [ ρ r + ( r r )] β As one would expect, ths probablty s ndependent of the government s actons. The probablty of a bank s falure s smply a functon of the rskness of ts portfolo and the pay-off to montorng, as represented by the nterest rate spread. 6 Any other strctly postve and convex functon V(m) would yeld qualtatvely the same results. 10 Workng Paper Seres No. 302
Explct depost nsurance Next, consdhuwkhfdvhzlwkh[solflwghsrvlwlqvxudqfhkhqfh D =1 and B (0,1). We allow for non-zero B to permt depost nsurance systems that credbly lmt coverage to depostors as well as depost nsurance systems, whch are not credble n ther lmtaton to depostors,.e. subordnated debt holders could be also baled out wth some non-zero probablty. In the followng we refer to a system wth a zero bal out probablty for subordnated debt holders as credble depost nsurance. The optmal level of montorng of a bank operatng n a non-credble system becomes * NC L B L (10) m = [ ρ r + (1 α )(1 γ )( r r )] and DI 1 β 1 1 β * C L L (11) m = [ ρ r + (1 α )( r r )] DI 1 β 1 1 β IRUDFUHGLEOHV\VWHPZLWK B =0. Comparng (10) to (8) t s clear that for non-zero levels of deposts or a non-zero probablty of a bal out of subordnated debt holders, the optmal level of montorng wth explct depost nsurance wll be less than n the free bankng case. Ths s also reflected n a hgher probablty of bank falure NC (12) 1 L B L p = ρ 1 [ ρ r + (1 α )(1 γ )( r r )] DI β n case the system s not credble and C (13) 1 L L p = ρ 1 [ ρ r + (1 α )( r r )] β 1 β 1 DI, f t s credble. The default probablty s strctly ncreasng wth the lkelhood that subordnated debt holders are also compensated n case of a bank falure. More B nterestngly, for γ << 1, equatons (12) and (13) show that the probablty of bank falure s also strctly ncreasng wth the share of deposts n bank labltes. Implct safety net Now turn to the case wth an mplct safety net. We defne an mplct safety net as an arrangement n whch all credtors of a bank are baled out n the case the bank fals D, S wth some probablty γ (0,1), but there s no explct depost nsurance. Hence, n 1 β 1 Workng Paper Seres No. 302 11
case of an mplct safety net, the bank s optmal level of montorng s just equaton (8), whch we restate here * L D L B L (7a) m = [ ρ r + α (1 γ )( r r ) + (1 α )(1 γ )( r r )] IS 1 β The optmal level of montorng depends on the probablty of bal out of both deposts and subordnated debt, as well as ther relatve shares n the bank s labltes. Usng equatons (11) and (7a) we can ascertan the relatve level of moral hazard under the mplct safety net versus an explct, credble depost nsurance system. We obtan the followng proposton: Proposton 1. For gven levels of rskness, and a gven assocated rsk premum, r L -r, the level of montorng under the mplct safety net s less than that under a credble explct depost nsurance ff B, IS γ (14) α < D, IS B, IS 1 γ + γ. 1 β 1 Proof: Follows drectly from equatons (7a) and (11). Proposton 1 states that moral hazard and the lkelhood of a bankng crss s reduced wth the ntroducton of credble explct depost nsurance relatve to an mplct safety net, f the share of subordnated debt (the share of nsured deposts) n bank labltes s relatvely hgh (low). Alternatvely, f the probabltes for a bal out of deposts and subordnated debt are hgh under the mplct system. Proposton 1 also mples that the effect on moral hazard of the ntroducton of explct depost nsurance n a country whch had been charactersed by wdespread mplct guarantees s ambguous ex ante. It depends upon whether the lmt of the safety net to depostors s ndeed credble, the share of subordnated debt on banks balance sheets and the prevalence of mplct guarantees pror to the ntroducton. Hence, the ntroducton of depost nsurance does not necessarly ncrease moral hazard. We can now state the probablty of default, p tis, under an mplct safety net system (15) 1 L D L B L p = ρ 1 [ ρ r + α (1 γ )( r r ) + (1 α )(1 γ )( r r) ] IS β In case of the mplct safety net, an ncrease n the probablty of depostor or subordnated debt holder compensaton (.e. hgher γ D and/or probablty of default, as montorng declnes and moral hazard ncreases. We can mmedately obtan a corollary to Proposton 1: B γ 1 β 1 ) ncreases the 12 Workng Paper Seres No. 302
Corollary 1. For gven levels of rskness, and a gven assocated rsk premum, r L -r, the probablty of bank falure s hgher under an mplct system than under credble depost nsurance ff B, IS γ (14a) α < D, IS B, IS 1 γ + γ, whch s exactly the same condton as for proposton 1 and follows drectly. Corollary 1 states that under the condton that the lmtaton of the safety net to depostors s n fact credble, a bank wth a hgher subordnated debt share should adjust ts rsk takng more than a bank wth a low subordnated debt share. Charter values, too bg to fal and balance sheet structure We wll now consder the effect of the exstence of charter values for banks rsk takng under the dfferent safety net arrangements. For that we modfy the banks pay-off structure as follows (16) 0-C wth a probablty (1 m ) and (17) r L t +C wth a probablty (1 ) + m. C represents a charter value, whch should be nterpreted as a fxed value of stayng n operaton, arsng from market power, reputaton or other factors. We assume that 0<C <1. The bank wll loose C f ts loan portfolo defaults and retans ths value f t succeeds. 7 Wth ths modfcaton, the bank s maxmsaton problem becomes (18) π = ρ (1 m )( C ) + V L (( 1 ρ ) + m ρ )[ r + C ] D D B B ( m ) r ( m, γ ) α r ( m, γ )(1 α ). Takng frst order condtons and re-arrangng yelds the optmal level of montorng wth charter values * L D L B L (19) m = [ ρ r + (1 + ρ ) C + α (1 γ )( r r ) + (1 α )(1 γ )( r r )] 1 β 1 β 1 Comparng equaton (8) to (19), one obtans Proposton 2 7 There are many other ways to model the presence of charter values. Generally, they requre mult-perod models. To mantan smplcty, we have abstracted from these ssues, as the queston of how a charter value may arse s not the focus of ths paper. For more dscusson, see Boot and Greenbaum [1993], Matutes and Vves [1997] and most recently Pelzzon (2001). Workng Paper Seres No. 302 13
Proposton 2. For gven levels of rskness, a gven assocated rsk premum, r L -r, and gven the safety net arrangements, the level of montorng wll be hgher n the presence of charter values. Corollary 2. Gven some non-zero level of subordnated debt ( <1), banks wth hgh charter values wll adjust ther montorng (and rsk takng) less than banks wth low charter values n response to a shft from an mplct safety net to explct depost nsurance. Proof: We prove the Corollary by showng that wth charter values less than 1, even f the bankng system s fully nsured, montorng could be as hgh as n the free bankng case. Suppose under the mplct safety net, D B we have γ = γ =1,.e. the bankng system s perfectly nsured aganst default. Settng equaton (19) equal L r r 1 + ρ to equaton (10) and solvng for C we obtan = < 1. C Corollary 2 gves us an mportant emprcal predcton. Banks wth hgh charter values, as they have less ncentves under the mplct safety net to take on excessve rsk, wll reduce ther rsk takng less upon the ntroducton of a credble depost nsurance system compared to banks wth low charter values. At ths pont, we are also n a poston to dscuss too bg to fal n the context of D B our model. Too bg to fal smply suggests that γ = γ =1 for large systemc banks, regardless of the safety net arrangements for all other banks. It s obvous that the optmal level of montorng wll be L (20) = [ ρ r ] 1 β 1 * 1 m TBTF. β Hence, we can state Proposton 3: Proposton 3. Banks that are too bg to fal wll not adjust ther rsk takng n response to the ntroducton of credble explct depost nsurance. deposts proposton: So far we have taken the balance sheet structure of banks as gven,.e. the share of was exogenous. Relaxng ths assumpton yelds the followng addtonal Proposton 4: Suppose the bank chooses frst and m only second. Then f D > B the bank chooses =1 f D < B the bank chooses =0 f D B the bank chooses α [0,1]. 8 Proof: Follows mmedately from (5). Proposton 4 has an mportant emprcal mplcaton: If a country moves from an mplct system, n whch the probablty of bal out for subordnated debt and deposts was equal 8 *LYHQ all prevous propostons and corollares hold. 14 Workng Paper Seres No. 302
or greater, to an explct system n whch the probablty of depostor compensaton s 1, banks wll adjust ther balance sheet structures towards relyng more heavly on nsured deposts. 9 In summary, the model n ths secton shows that the effect of ntroducng explct depost nsurance on banks rsk takng may be ambguous ex ante and depends on assumptons about the counterfactual to depost nsurance (no safety net vs. an mplct safety net). The model yelds a number of emprcal predctons regardng moral hazard and rsk takng of banks. In Sectons VII and VIII, we use a data set of European banks to test for Propostons 1 and 2 as well as Corollares 1 and 2, and for Propostons 3 and 4. III. Insttutonal background As we propose to test the model usng European data, t may be useful to gve some background nformaton on the regulatory envronment n Europe. Bankng deregulaton n Europe began n the late 1970s and contnued through the early 1990s, wth sgnfcant dfferences n the tmng and speed of the process across countres (Canals [1993]). Wth few exceptons, regulatons on banks compettve conduct have now largely been elmnated. These regulatons ncluded controls on banks depost and lendng rates, fees and commssons, as well as drect credt quotas and branchng lmtatons. Functonal separaton of fnancal nsttutons, f t exsted, has generally ceased. There was a shft n regulatory thnkng from conduct regulatons towards the use of prudental regulatons (captal adequacy, exposure concentraton lmtatons), freeng competton and abolshng regulatory protecton of natonal markets. However, some country specfc dstortons reman, manly related to taxaton and subsdes, but they dstort bankng markets to a much more lmted extent than n the past. Whle conclusve emprcal evdence s stll outstandng, the result of deregulaton s generally beleved to be a sharp ncrease n bankng competton. European Communty legslaton, prmarly snce the Whte Paper of 1985 Completng the Internal Market, has sgnfcantly contrbuted to ths process and has provded ncentves for natonal legslators to deregulate and streamlne bankng legslaton. The most mportant pece of Communty legslaton was the 2 nd Bankng Coordnaton Drectve (89/646/EEC) leadng to unfcaton of the regulatory framework for entry control and cancellng the major elements of natonal separaton of markets n legal/regulatory terms. The Drectves on banks own funds (89/299/EEC) and requred 9 Clearly, we do not observe banks fully fnanced wth ether subordnated debt or nsured deposts; rather banks tend to use a combnaton of both. One smple way to reconcle ths stylsed fact wth our model would be to ntroduce some fxed supply of nsured deposts (as depost nsurance s lmted to some amount per depostor). Workng Paper Seres No. 302 15
solvency rato (89/647/EEC) were adopted wthn the same tme frame. However, these regulatons n effect extended the scope of the 1988 Captal Accord of the Basel Commttee on Bankng Supervson ssued for nternatonally actve banks to all banks n the EU. The Basel Accord meant on one hand an mportant change n bankng regulaton away from ntrusve conduct regulatons towards greater relance on prudental standards. On the other hand, t ntroduced more strngent captal requrements, whch may have nfluenced banks rsk takng. We wll use n the emprcal analyss the mplementaton of the 2 nd Bankng Drectve as a summary proxy for the ultmate deregulaton process, whle recognsng that sgnfcant aspects of deregulaton affectng bankng competton and banks rsk takng ncentves took place also before the mplementaton of ths Drectve. Central n the context of ths paper a Drectve on Depost Guarantee Schemes (94/19/EC) was ssued, n order to support the orderly functonng of bankng markets under the lberalsed envronment. It set the mnmum formal depost guarantee at 20 000 euro. 10 At the tme of the drectve, four EU countres dd not have explct depost nsurance: Fnland, Greece, Portugal and Sweden. Greece and Portugal ntroduced depost nsurance n 1996, Sweden n 1997 and Fnland not untl 1999. 11 We use ths crosscountry and tme seres varaton n the econometrc analyss below to dentfy the effects of depost nsurance on bank behavour. None of the EU schemes guarantee nterbank deposts and all have lmts of the coverage per depostor (Appendx I). Other debt nstruments ssued by banks are all outsde the scope of the coverage, whle some schemes may provde a lmted coverage. IV. Data sources and descrpton The data used n ths study were obtaned from a number of dfferent sources. The balance sheets and the ncome statements of EU banks are from the Ftch-IBCA Bankscope data set, whch contans balance sheet data for a wde varety of European banks. We used consoldated balance sheets, supplemented by unconsoldated balance sheets for banks, whch dd not have consoldated data n Bankscope and dd not have sgnfcant subsdares. We retaned those banks for whch we could ascertan market values usng Datastream, as market values are necessary to calculate our measure of charter value, q and whch exsted under the same name throughout the sample perod. 12 10 Ths was requred to exst n all EU Member Countres by 1 July 1995. A lmtaton to Ecu 15,000 was possble untl 31 December 1999. 11 Belgum, Ireland, Luxembourg and the Netherlands had a coverage lower than 20 0000 euro before the Drectve. 12 Ths mples that some banks n the sample may have taken over smaller banks durng the sample perod. 16 Workng Paper Seres No. 302
Ths process yelds a sample of 128 banks for 1991-1998. A few of the banks recorded by IBCA only report partal nformaton on mportant data tems. We used lagged varable regresson or bank-specfc means to mpute these mssng values. We also excluded 1991, as n Bankscope no nformaton was avalable for all French banks and a large number of Italan banks, and we wanted to keep these mportant bankng markets n the sample. The end result s a balanced panel contanng 128 banks wth data from 1992 to 1998 and a sample sze of 896 observatons. We supplemented ths bank specfc nformaton wth the stock market ndex for the country of orgn of the bank, whch we also obtaned from Datastream. Datastream also provded us wth the nter-day volatlty of share prces, whch we use n the rsk equatons. Other fnancal varables collected are 10-year Government bond yelds as a measure of the long-term nomnal nterest rate and the money market rate as a nomnal short-term nterest rate. The rates were obtaned from the IMF s Internatonal Fnancal Statstcs. The resultng sample contans data for banks n all 15 EU countres (Table 1). The composton by country broadly corresponds to market sze wth the excepton of the UK and Sweden, for whch market values for banks were dffcult to obtan n Datastream. Table 2 gves some descrptve summary statstcs for the banks n the sample. The banks are relatvely large, the average total assets s $48 bllon. The banks, hence, are approxmately seven tmes the average sze of all EU banks n the Bankscope. We attrbute ths sze dfference to our requrement that the banks be traded at a stock exchange. The sample banks represent approxmately one sxth of the total assets of the EU bankng sector. The banks n our sample qute accurately reflect the some of the stylsed facts n European bankng. For example, whle the overall mean of the share of non-nterest earnngs n total earnngs s 32.5 percent, ths share has contnuously ncreased from 27 percent n 1992 to 38 percent n 1998. Interestngly ths s not reflected n the share of loans n total assets, whch has remaned approxmately constant around the overall sample mean of 55 percent. V. Defntons of dependent and ndependent varables We are partcularly nterested n the effect of depost nsurance on bank behavour. Gven the cross-sectonal and tme seres varaton n depost nsurance n EU countres we are able to explctly control for the effect of the exstence of depost nsurance. We create an ndcator varable, whch s equal to one when no system s n place, whch was the case n Greece, Portugal untl 1995, for Sweden untl 1996 and for Fnland for the entre sample perod. We also created an ndcator capturng dfferences n depost nsurance coverage. The ndcator equals one when coverage s extraordnarly hgh (Italy Workng Paper Seres No. 302 17
and France, whch had coverage levels of 6 to 12 tmes the sample average, respectvely and Germany, where the coverage s lmted only by the book value of captal of the bank). Detals on the coverage of EU depost nsurance schemes, as well as other detals are gven n Appendx I. Fnally, n order to measure the mpact of deregulaton, we created an ndcator, whch reflects the mplementaton date of the Communty legslaton through the 2 nd Bankng Co-ordnaton Drectve. The ndcator equals one after the actual mplementaton date and mples that we model the lberalsaton based on the Drectve as a structural shft. 13 A bank s charter value can be defned as the present value of the stream of profts that t expects to earn when stayng n busness. Hence, the charter value would equal to the market value (present value of the future expected earnngs/dvdend) of ts assets mnus the replacement cost of the bank,.e. the expense of rebuldng the exstng bank from scratch (Demsetz et. al. [1996]). The market value s set to equal the market value of equty (E) (stock prce tmes the amount of equtes outstandng) plus the book value of banks labltes (L). Ths s reasonable, snce the value of gong concern would be reflected n the market value of the equty, as the equty holders would be the benefcares, not the debt holders. The replacement cost of a bank s smply the book value of ts assets (A). Hence, the charter value (CV), whch s dvded by the book value of assets n order to obtan a scale-free measure, can be expressed as: (21) CV A E + L A =. A Addng 1 and smplfyng gves Tobn s q, whch n the followng wll be used as a proxy for a bank s charter value: (22) E + L q =. A Ths measure s also used by Keeley [1990] and Demsetz et. al. [1996]. For a bank wth prcng power n loan, depost or other markets, the market value of assets (E+L) would exceed ther book value (A), and q would exceed one. In equlbrum q would exactly equal one for an unnsured bank wth no prcng power. The measure q as a proxy for charter value has the advantage of permttng comparablty across dfferent bank szes. Furthermore, t drectly reflects the extent of monopoly rents earned by banks due to prcng power. Smrlock [1984] argues that 13 Note that even though the Drectve was passed at the European level, the mplementaton dates vary n the ndvdual countres: The Netherlands and Sweden (1991), UK (1992), France, Germany, Portugal, Greece, Ireland and Italy (1993), Austra, Belgum, Fnland and Luxembourg (1994), Span (1995), and Denmark (1996). 18 Workng Paper Seres No. 302
because q relates the market value of banks assets to ther current cost, t s an deal alln measure of the rents. Any prcng power, rrespectve of ts source, would be reflected n the market value of banks equty, and thus assets, but not n the cost of acqured assets. Ths crcumvents also the sgnfcant measurement problems n tryng to proxy the extent of prcng power through nterest rates charged by banks for loans and deposts, and even more so through accountng-based measures of margns whch can be drven by many auxlary factors and accountng peculartes. 14 In the regresson analyss we also utlse balance sheet ratos to control for bank specfc dfferences, ncludng the share of deposts n total labltes, the share of nonnterest earnngs n total earnngs, and the share of loans n total assets. The share of nonnterest ncome n total ncome was ncluded to measure the bank s wllngness and ablty to dversfy nto non-lendng, non-tradtonal actvtes, such as underwrtng and to some extent wll also proxy for the bank s nnovaton ablty. In the relatonshp between moral hazard and depost nsurance the montorng of unnsured debt-holders may be qute mportant, as dscussed n Secton II. Therefore, we ncluded the share of subordnated debt n total labltes as an ndependent varable. In the European context, wth sgnfcant dfferences n the sze of countres economes, we use the share of the bank s total assets n the total assets of the country s bankng system to control for the too-bgto-fal effects on charter value and rsk takng. Further, we nclude a normalsed country specfc stock market ndex 15, money market rates and a measure of the steepness of the yeld curve, whch we defned as the dfference between money market rates and 10-year government bond yelds. Fnally, not all banks n the sample were commercal banks. We also had a lmted number of cooperatve banks and mortgage banks, whch mght experence valuatons that are qute dfferent from those of commercal banks. Specalsed banks or banks wth a somewhat dfferent organsatonal form mght face dfferent constrants, as well as pursue dfferent objectves relatve to commercal banks. 16 For defntons of all varables see Appendx II. 14 A problem may arse n usng q as a measure of banks rents (or charter value), as the book value of assets reflects hstorcal costs, rather than current costs of the assets. Therefore, ex post q may dverge from 1 smply because asset return realsatons may have been dfferent from expectatons, rather than as a reflecton of market power. Hence, the theoretcally correct ex ante q s measured wth error when usng the ex post q. One could also argue that q and rsk takng may be smultaneously determned. Ths would suggest an nstrumental varable approach. We expermented wth a number of nstruments, but were unable to fnd one wth an economc justfcaton. 15 The respectve stock market ndces were normalsed, such that for all countres 1991=100. Ths wll ensure comparablty across countres. 16 Wth few exceptons, our choce of control varables corresponds closely to those of Keeley [1990]. Workng Paper Seres No. 302 19
VI. Econometrc model and baselne results We estmate the followng reduced form model: (23) rsk jt = δ + δ1dt + Π1X jt + Π 2Ct + u + ε 0, where rsk jt represents a measure of rskness for bank j at tme t, D t represents a set of ndcator varables descrbng the depost nsurance system and the degree of deregulaton n country at tme t, X jt represent a set of control varables unque to bank j at tme t, and C t are country specfc control varables. Equaton (23) s estmated usng country-specfc fxed effects n order to control for country specfc dfferences, whch are unaccounted for n the control varables. These country specfc effects pck up any other polcy dfferences across countres, whch are not ncluded explctly n the set of control varables (such as taxes and any remanng dfferences n natonal bankng regulatons). The dfferent measures of bank rsk are dscussed below. In lne wth the theoretcal lterature (e.g. Matutes and Vves [1995]), we dstngush between the three dfferent types of rsk: leverage rsk, asset rsk and overall bank rsk. Leverage rsk s defned as the book value of debt dvded by the market value of assets (the market value of equty plus the book value of labltes). It measures the degree of gearng of the bank; the more hghly geared a bank s, the rsker t, as ts cushon aganst an unexpected deteroraton n the qualty of ts assets s smaller than n a less leveraged bank. Hgher gearng may also reflect a readjustment n the balance structure towards deposts (Proposton 4). Our second measure of rsk, asset rsk, s approxmated by usng the share of problem loans n total assets. Fnally, we use the nter-day volatlty of the bank s share prce, corrected for the market component as a measure of the overall rsk of the bank. We defned the volatlty as (24) Sd tj [Ln [p d /p d-1 ]]* n. for any year t and bank j, where p d represents the stock prce on day d, n represents the number of tradng days and Sd s the standard devaton of the daly stock prce durng perod t. From (24) we extracted the non-dversfable component. Ths was done, as we were concerned that our measure of overall rsk may be drven by the volatlty of the market portfolo rather than by non-dversfed rsk. Hence, we estmated a standard market model and calculated the standard devaton of the resduals, whch gves us a measure of dosyncratc volatlty. For the detals of the calculaton see Appendx III. All three measures suffer from shortcomngs. In partcular, our measure of leverage would beneft from a market-based measure of labltes, whch we dd not have access to. The measure of asset rsk s backward lookng, not a measure of current rsk, as default or payment dffcultes of the clents of a bank wll only appear n our measure wth a lag. For example, the bank may extend further loans, whch enable ts troubled customer to 20 Workng Paper Seres No. 302
reman current on the ntal credt. And thrd, dfferences n nter-day volatlty may not only reflect the rskness of a bank, but also the lqudty depth of the market for ts shares, although we would consder ths problem to be relatvely small gven the sze of the banks n our sample. The baselne estmates for the relatonshp between rsk and depost nsurance are presented n Table 3. Table 3 shows that banks tend to reduce ther rsk takng for two of the three measures of rsk n response to the ntroducton of explct depost nsurance. Conflctng evdence s provded by the thrd measure: Leverage rsk tends to ncrease wth explct depost nsurance. Ths s weak evdence n favour of Proposton 4; namely that banks ncrease ther share of nsured deposts when explct depost nsurance s ntroduced. In the next secton, we wll present evdence, whch more drectly addresses ths ssue. For asset rsk and overall rsk, the absence of explct depost nsurance s assocated wth sgnfcantly hgher rsk takng. 17 The effects of the 2 nd Bankng Drectve on rsk takng appear to have been mxed. We fnd a weakly postve effect on leverage and asset rsk. Overall rsk, as measured by the dosyncratc stock prce volatlty, s lower after the mplementaton of the drectve, whch we nterpret to reflect the tghter solvency standards assocated wth the drectve. Now turn to the effect of changes n the charter value (q) on rsk takng. As argued n the lterature, banks wth hgher charter values tend to exhbt lower levels of leverage and overall rsk (Proposton 2). 18 The estmates for the control varables largely conform to expectatons. For example, banks wth a hgher proporton of loans n ther portfolos have also a hgher proporton of problem loans and, hence, more asset rsk, but generally are not rsker overall. Banks wth a hgher share n the total assets of the bankng system n ther country are more hghly leveraged, but also not rsker overall. Ths suggests that these banks may be better dversfed and, hence, hold less captal. We fnd some evdence that subordnated debt holders are able to exert nfluence on the rsk takng of banks (corollary 1). The coeffcent has the expected sgnfcantly negatve sgn for overall rsk. Interestngly, t s postve for leverage rsk, suggestng some substtuton of ter 1 (equty) and ter 2 (subordnated debt) captal. We provde further evdence on the queston of subordnated debt holder montorng below. 17 Hgher coverage s not assocated wth an effect on banks rsk, whch s consstent wth our argument that what matters s not the characterstcs of the scheme, but rather ts exstence n the sense of leavng some credtors of the bank uncovered altogether. 18 Ths s consstent wth the prevous emprcal lterature usng US data (e.g. Keeley [1990], Demsetz et.al. [1996], Grossman [1992], McKenze et. al. [1992], Brewer and Mondschean [1994]) and Furlong and Keeley [1989]). Workng Paper Seres No. 302 21
Ex ante, we had no strong prors on the effects of market condtons on rsk takng. A hgh stock market may suggest a favourable economc envronment and, hence, would be assocated wth lower rsk of banks portfolos. Ths s reflected n the sgnfcantly negatve coeffcent of the stock market ndex on asset rsk. However, we also fnd that leverage and stock prce volatlty ncrease when stock markets are hgh. Smlar arguments apply to the effects of nterest rates. Whle we have taken care to use a number of dfferent measures of bank rsk and found sensble results across all measures, we were concerned that the results may tell us lttle about the effect of depost nsurance, but rather hghlght dfferences n countres unrelated to depost nsurance. Recall that the group of countres wthout depost nsurance ncludes Fnland (throughout the sample perod), Greece, Portugal (untl 1995) and Sweden (untl 1996). We consdered the possblty that coeffcent on the dummy on the absence of explct depost nsurance smply measures that these countres are dfferent from the remander of the sample for reasons completely unrelated to depost nsurance. For example, both Fnland and Sweden experenced bankng crses at the begnnng of our sample perod; t s possble that ths may be drvng our results. 19 Regardng Greece and Portugal, we were concerned that our results could reflect the fact that the bankng sector n these countres may have been less developed or otherwse dssmlar from the core EU countres. The country dfferences mght also reflect dfferences n ntensty of bank regulaton and supervson, whch are unrelated to depost nsurance and the country effects are too crude a measure to pck up these dfferences. In order to address these concerns, we have taken two complementary approaches. One, we nteract the depost nsurance ndcator wth bank specfc characterstcs, such that the effects of depost nsurance are dentfed usng bank characterstcs, rather than country characterstcs. And second, we lmt our sample to the countres that at some pont dd not have explct depost nsurance (Fnland, Sweden, Portugal and Greece) and estmate the effects of the ntroducton of explct depost nsurance relyng largely on tme seres evdence. 19 Note, however, that we could argue that t may not be a concdence that bankng crses occurred n two countres wthout depost nsurance. Ths s the opposte pont of the one n Demrgüç-Kunt and Detragache [2002]. 22 Workng Paper Seres No. 302
Identfcaton usng bank characterstcs Frst consder the followng ndcators, whch we nteract wth the no depost nsurance ndcator: A set of ndcators, whch dstngush between banks wth subordnated debt shares above and below the medan of the dstrbuton, whch permts us to test for Corollary 1. The share of subordnated debt s used as a proxy for unnsured debt more generally, as we were able to measure t more accurately than the other debt categores. A set of ndcators, whch dstngushes between banks wth hgh charter values (charter values greater than 1) and other banks. Ths would allow testng for Corollary 2. A set of ndcators, whch dstngush banks, based on ther relatve sze n the bankng system. We set the cut-off pont at banks wth more than 12 percent of the total assets of a bankng system n ther country of ncorporaton, whch represents the 90 th percentle of the dstrbuton. The falure of banks wth such a hgh share n the total assets of the bankng system would clearly represent a systemc rsk to the bankng system as a whole. Hence, ths dstncton allows us to test Proposton 3. Table 4 dsplays the results for ths exercse. We have lmted the table to the nteracton terms, as they are of partcular nterest. 20 Consder frst the nteracton terms wth subordnated debt. We fnd evdence n favour of the noton that subordnated debt may act as market-based lmt to moral hazard and excessve rsk takng of banks (Corollary 1). For asset rsk and overall rsk, banks wth hgher subordnated debt shares reduce ther rsk takng more than those wth lower subordnated debt shares and the dfference s sgnfcant at the 5 percent level n the case of asset rsk (and margnally sgnfcant at the 10 percent level for overall rsk). Ths fndng s especally strkng as we fnd further evdence for Proposton 4, namely that banks have ncreased ther leverage n response to the ntroducton of explct depost nsurance (see below). It also further corroborates the noton that explct depost nsurance was credble at lmtng nsurance to depostors. Second, for the charter value/no depost nsurance nteracton terms, we fnd support for Corollary 2. In case of asset and overall rsk banks wth hgh charter values do not adjust ther rsk takng downwards n response to the ntroducton of depost nsurance and banks wth low charter values do. For asset rsk, we can reject that the two coeffcents are equal at the 5 percent confdence level. Hgher charter values act as 20 The coeffcents on all other varables are robust to the ntroducton of these nteracton terms. The complete results are avalable from the authors upon request. Workng Paper Seres No. 302 23