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Bank Governance, Deposit Insurance and Banks’ Risk-taking

Apanard P. Angkinand Milken Institute, Santa Monica, CA

Clas Wihlborg Argyros School of Business and Economics, Chapman University, Orange, CA and Copenhagen Business School e-mail: [email protected] Preliminary May 29, 2010

Abstract: Using bank level data for industrialized and emerging market economies we estimate how deposit insurance systems and governance structures of banks affect the degree of market discipline on banks risk-taking. Market discipline is influenced by explicit deposit insurance systems and implicit insurance of banks’ creditors. Furthermore, market discipline depends on the responsiveness of bank managers to market incentives. An expected U-shaped relationship between explicit deposit insurance coverage and banks’ risk-taking is influenced by country and bank specific institutional factors, including bank ownership. We analyze specifically how government ownership, foreign ownership, and concentration of ownership affect the disciplinary effect of partial deposit insurance systems in industrial countries and in emerging market economies.

JEL Classification: G21; G28; F43 Keywords: Deposit Insurance; Banking Crisis; Non-performing Loans, Market Discipline; Bank Ownership; Bank Governance

1. Introduction

Deposit insurance and implicit insurance of banks’ creditors have been pointed to among the many explanations for the financial crisis offered in the policy debate. Shareholders have incentives to shift risk to tax payers and deposit insurance funds to the extent creditors do not require a risk premium for lending to banks with relative high likelihood of default unless regulators charge a risk-based insurance premium. 1 The financial crisis has also been linked in the debate to compensation schemes for executives and other employees in the financial industry. These schemes represent one aspect of corporate governance which may be more or less effective from the point of view of shareholder wealth maximization. Since the argument for risk-shifting with insurance of banks’ creditors is based on shareholder wealth maximization it should be expected that the degree of risk-shifting depends on the corporate governance system as well as on the extent of explicit and implicit insurance. Angkinand and Wihlborg (2010) develop and test hypotheses for the impact of explicit insurance and ownership characteristics on risk-taking on the country level focusing foreign and state ownership among governance variables. They take implicit insurance into account only to the extent it depends on the coverage of explicit deposit insurance. In this paper we consider two dimensions to implicit insurance of banks’ creditors along with bank-specific as well as country specific aspects of corporate governance. The two dimensions to implicit insurance are “too big to fail” and the dependence of implicit insurance on explicit deposit insurance coverage. This dependence exists because lack of insurance of banks’ creditors is not credible unless the explicit coverage of deposits is substantial. Increased explicit coverage reduces the policy incentives to bail out banks in distress while lack of explicit insurance of depositors compels governments to respond quickly to signs of crisis by offering, for example, a blanket guarantee to banks’ creditors to discourage bank runs. Bank governance is characterized by the degree to which management’s objective is consistent with shareholder wealth maximization. From a risk-taking perspective bank governance plays an ambiguous role. If banks’ creditors require a risk premium for high risktaking, shareholder wealth maximization implies the existence of market discipline on risktaking. On the other hand, excessive risk-taking may lie in shareholders’ interest if there is extensive implicit or explicit insurance of banks’ creditors.

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There are countries charging a risk-based premium on explicit insurance but the risk measures used are very crude.

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We use data for 284 banks in 39 industrial and emerging market economies during the period 1994-2005 to analyze how explicit and implicit protection of banks’ creditors affect risktaking in banks with different corporate governance characteristics. We draw on the corporate governance literature to identify characteristics that can serve as proxies for degree of shareholder maximization. Risk-taking is measured by market-based so called z-scores as well as by non-performing loans. Our sample is limited by the availability of the data for bank governance and ownership on the level of individual banks. Hypotheses are tested for the whole sample of countries as well as for industrialized and emerging market countries separately. Risk-taking in Asian countries is thereafter studied separately with information about specific characteristics of banks and deposit insurance systems in these countries. We ask whether the relatively mild impact of the financial crisis on Asian countries can be explained to some extent by corporate governance and the nature of insurance of banks’ creditors. In Section 2, we review existing evidence on the impact on risk-taking and market discipline of deposit insurance schemes and bank governance characteristics. Hypotheses with respect to risk-taking are developed in Section 3 with an emphasis on the role of credibility of non-insurance and the effect of governance characteristics on risk-taking. In section 4 the empirical methodology and data are described. Results are presented and discussed in Section 5. The results are applied on Asian countries in Section 6. Conclusions and implications follow in the last section. The empirical results reveal the hypothesized U-shaped relationship between risk-taking and explicit deposit insurance coverage in both industrialized and emerging economies, reflecting that extensive non-insurance of banks’ creditors is not credible. Explicit bank-specific proxies for implicit insurance as a result of “Too Big to Fail” do not appear significant, however. We analyze how bank capital, ownership concentration, foreign ownership and state control of banks affect risk-taking incentives at different levels of explicit deposit insurance coverage.

2. Evidence on deposit insurance, bank governance and risk-taking Deposit insurance should prevent the spread of bank runs in an environment where information about individual banks’ risk-taking is limited (Diamond and Dybvig, 1983). The protection of banks’ depositors and other creditors also reduces incentives to monitor banks’

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risk-taking. Thereby, banks’ shareholders have incentives to shift risk to the entities protecting the creditors unless banks are charged a risk-adjusted insurance premium. The entities could be a deposit insurance fund or tax payers. Financial regulation of various kinds has been suggested to control moral hazard incentives associated with both explicit and implicit deposit insurance. Strict supervision in combination with limited forbearance is one approach. Capital requirements that limit the ability and incentives of banks to shift the risk away from shareholders is another. The Basel Committee’s work on capital adequacy rules is partly motivated by these concerns. Requirements for banks to hold full reserves against deposits in the form of highly liquid securities have also been suggested (Miller, 1998). Several empirical studies show that effects of explicit deposit insurance on banks’ risk taking depends on characteristics of the institutional environment. Demirgüç-Kunt and Detragiache (2002), Barth et al. (2004) and Cull et al. (2005) find that high quality of domestic institutions and legal systems reduces the moral hazard effect of deposit insurance. Hovakimian et al. (2003) emphasize that effects of explicit deposit insurance depend on its design and credibility. Ferńandez and Gonźalez (2005) find that the adverse effect on risk taking can be reduced by enhancing the effectiveness of accounting and auditing systems. Gonzales (2005) suggests that the observation in some papers that deposit insurance reduces risk-taking can be explained by the positive impact of deposit insurance on banks’ charter values in a strictly regulated environment. Strict regulation reduces charter values and, therefore, induces greater risk taking, while deposit insurance mitigates these effects. Other studies including Angkinand and Wihlborg (2010), Gropp and Vesala (2004) and Nier and Baumann (2006) emphasize the role of implicit insurance as a contributing factor to excessive risk taking of banks. Based on a sample of European banks Gropp and Vesala (2004) find that explicit deposit insurance is associated with lower moral hazard and reduced risk taking if banks have large uninsured liabilities and small assets relative to the total assets of a banking system. These results indicate that a bank’s market share affects implicit insurance. Angkinand and Wihlborg (2010) hypothesize and estimate a U-shaped relationship between explicit deposit insurance coverage and banks’ risk-taking using country-level data. The U-shaped relationship implies that banks’ incentives to shift risk to a deposit insurance fund is minimized by a deposit insurance system offering a partial deposit insurance coverage because market discipline is likely

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to be weak at low as well as high levels of deposit insurance coverage. The weak discipline at low levels is caused by a high likelihood that governments find themselves compelled to issue blanket guarantees to creditors of distressed banks, or to bail them out. The weak discipline at high levels is due to moral hazard generated by high deposit insurance coverage. Nier and Baumann (2006) study the market discipline effect for individual banks. They analyze banks’ risk taking as a function of bank capital, market discipline variables, transparency measures, and a number of country and bank specific control variables. Risk-taking is measured by the share of non-performing loans in total assets, by provisions for non-performing loans and by the volatility of the bank’s equity market return. Market discipline is measured by the extent of deposit protection on the country level, the amount of uninsured funding, and the extent of government support on the bank level to capture implicit insurance. Their results indicate that lack of explicit deposit insurance and high amounts of uninsured deposits are likely to reduce risk-taking through the impact on increasing desired capital while the likelihood of government support reduces market discipline both directly and through the effect on desired capital. Another strand of literature focuses on market discipline imposed by the existence of subordinated debt. Such debt should have a relatively low level of implicit insurance. Market discipline is captured by the sensitivity of yields to changes in banks’ risk-taking, as well as by the effects of changes in yield on bank behavior. Using American bank data Jagtiani et al (2002) find evidence that the yields on subordinated debt are sensitive to banks’ risk-taking while the impact of changes in yield on bank behavior is less clear. Sironi (2000) obtains similar results for European banks. Distinguin et al (2005) analyze whether banks’ stock returns reflect information about bank risk by asking whether the returns contribute to predictions of distress for individual banks in Europe. Distress is defined as a two-step decline in ratings within a year. They find weak predictive ability of stock returns when controlling for a number of observable factors. The existence of predictive ability would indicate that stock markets contribute to market discipline. Risk-taking incentives of bank managers can be expected to depend on the their objectives and, therefore, on the governance structures of banks. In the literature, it is usually assumed that managers in a “good” governance structure maximize shareholders’ wealth while the incentives to serve the interests of other stakeholders are provided by market forces, law, and regulation.

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There is a limited number of studies on bank governance and most of them are a countryspecific studies. For instance, Saunders et al (1990) using a sample of 38 bank holding companies in the U.S. during 1978-85 find a positive relation between managerial ownership and risk-taking. On the other hand, Chen et al. (1998) find a negative relation between managerial ownership and the level of risk taking in a larger sample of 302 banks and savings institutions during the period 1988-1993. Their explanation is that managers become more risk-averse when their ownership stake increases. Risk-taking is measured by the volatility in daily stock returns and market interest rates. 2 Related studies focus on the impact of ownership on risk-taking and performance. Several studies indicate that state ownership of banks leads to inefficiency and poor performance (e.g. La Porta et al., 1998). One reason is that management in these banks could often come under pressure to serve particular political interests. Caprio and Martinez-Peria (2000) find evidence that a greater extent of state ownership of banks is associated with a higher likelihood of banking crises in developing countries during 1980-1995. Barth et al. (2004) and Berger et al. (2005) find that state-owned banks have a relatively high ratio of non-performing loans to total loans. However, Barth et al. do not find a significant impact of state ownership on banking crises, bank development and performance as measured by net interest margins and overhead costs. Byström (2004), on the other hand, find that the degree of state ownership is positively related to the bank failure rate prior to crises. The large share of foreign ownership of the banking sectors in many emerging market economies in Eastern Europe and Latin America has stimulated research on the effects of foreign ownership on banking operations there. According to Lensink and Hermes (2006) the entry of foreign banks improves the performance of domestic banks although costs increase as well. Lensink and Naaborg (2006) focus on the transition economies and the expanding foreign ownership of banks, while Crystal et al. (2001) study Latin American experiences. The results indicate that foreign banks grow faster than domestic banks, and that they have greater loss absorption capacity. Foreign banks bring benefits to the domestic banking sector by bringing in technology and expertise in risk management. They also increase competition, thereby forcing 2

Anderson and Fraser (2000) argue that the different results can be explained by changes in the regulatory environment between the 80s and the 90s. These changes affected banks’ charter values in the USA. In the Japanese banking sector Konoshi and Yasuda (2004) observe that the relationship “between the stable shareholders’ ownership and bank risk is nonlinear”.

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domestic banks to increase efficiency. It has also been argued, however, that the intensified competition could induce weak domestic banks to take more risk. The evidence with respect to effects of foreign ownership on banks’ risk taking is mixed. Demirgüç-Kunt et al (1998) and Claessens et al. (2001) find that foreign ownership of banks is associated with lower financial fragility. Barth et al. (2004) find that the degree of foreign ownership could not explain the likelihood of banking crisis but restrictions on foreign bank entry and ownership are significantly associated with a higher likelihood. The importance these restrictions are supported by Levine (2004) in a study of bank level data for 47 countries. He finds that restrictions on the entry of foreign banks, not ownership, increase interest margins. Caprio et al. (2004) and Barth et al. (2006) analyze whether the quality of bank governance across countries is influenced by rules with respect to shareholder rights and disclosure. They use the market to book values of banks as a proxy for quality of governance. The results show that greater transparency and stronger minority shareholder rights are associated with higher market values but also that concentration of ownership substitutes for shareholder protection. Tadesse (2005), Fernandez and Gonzalez (2005), and Nier and Baumann (2006) find that greater disclosure and transparency strengthen market discipline and reduce risktaking of banks. Using country level data Angkinand and Wihlborg (2010) ask whether ownership and shareholder rights influence the relationship between risk-taking and deposit insurance coverage. They find that deposit insurance coverage has little effect on risk-taking in countries where a large part of the banking system is foreign controlled while stronger shareholder rights reduce the risk-taking incentives associated with implicit deposit insurance in particular.

3. Credibility of Non-insurance, Risk-taking and Governance; Hypotheses Banking crises tend to occur without much warning and, as a result, policy makers must react very quickly to stave off any threat to the financial system as a whole and to the payment system in particular. Many economists argue that the fear of contagion from one bank’s distress to crisis for the banking system as a whole is exaggerated even if the bank has a substantial market share. 3 However, as we have seen in the recent crisis governments cannot allow themselves to bide the time to see whether this hypothesis is correct. If the economists are wrong 3

See, for example, Benston, et al. (1986).

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the costs of a systemic crisis will be politically unacceptable. The government and supervisors cannot wait to see whether a large bank is truly insolvent or only has a liquidity problem and, in case of insolvency, they cannot allow normal corporate insolvency procedures to work themselves out before creditors’ claims are honored fully or partially. An important function of the banking system is to supply liquidity and lack of trust in the banking system as a whole can rapidly become very costly. Central banks provide liquidity assistance to banks in distress but the difficulty of distinguishing between liquidity- and insolvency crises in combination with the fear of contagion tends to compel governments to secure a distressed bank’s survival if they fear systemic repercussions one way or another. 4 Different ways of securing a bank’s survival have different implications for shareholders, in particular. Depositors and other creditors rarely face losses however. Issuing a blanket guarantee of creditors tend to benefit shareholders as well, while nationalization and temporary public administration can cause shareholders to lose their entire stake. 5 In case the distressed bank is merged with another bank, shareholders would typically obtain some stake in the merged entity. The empirical evidence in Angkinand (2008) indicates that costs of crises are relatively high in countries with low explicit deposit insurance coverage. Thus, the governments’ incentives to intervene quickly to protect banks from the risk of runs are particularly strong in these countries. If so, implicit insurance becomes relatively strong in countries with low explicit deposit insurance coverage. Keefer (2001) analyze the political forces and costs associated with banking crises. Assuming that market participants understand these costs, implicit insurance is strengthened since the credibility of non-insurance becomes weak. Many countries including the US and members of the EU have introduced partial deposit guarantee schemes in order to reduce the risk of runs of such magnitude that banks must be closed while retaining an element of market discipline. The magnitude of explicit coverage, as well as the types of deposits covered by insurance, varies considerably from country to country. The question policy-makers face is what coverage is needed to reduce the risk of runs to an acceptable level while also providing a degree of market discipline. If the risk of severe runs 4

Honohan and Klingebiel (2003) and Caprio and Klingebiel (2003) review a large number of banking crises and governments’ responses and resolution policies. 5 In the USA the FDIC becomes the receiver or conserver of a bank when its capital ratio falls below two percent. Few other countries have laws specifying how authorities should act relative to a bank approaching or in distress.

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remains high at a partial level of coverage, non-insurance of relatively large deposits would not be credible. 6 The discussion so far implies that the effect of explicit insurance schemes on banks risktaking incentives depends on three factors: the coverage of the explicit deposit insurance system, the credibility of non-insurance of those not covered by the explicit system and the relation between the coverage of explicit insurance and the credibility of non-insurance. Figure 1 from Angkinand and Wihlborg (2010) illustrates our argument and the hypothesis that there is a partial level of explicit coverage that minimizes banks’ risk-taking in a country. On the horizontal axis we have the extent of explicit insurance coverage (EC) of deposits and other claims on banks. On the vertical axis we have the incentives of banks to take risk (RT) given macroeconomic conditions, governance structure, capital requirements, efficiency of supervision and other institutional characteristics affecting the credibility of a government’s deposit insurance system. We interpret risk-taking (RT) as the probability of a bank’s capital buffer being exhausted within a certain timeframe. In Figure 1 the line denoted “Explicit” shows how market discipline declines and risktaking (RT) increases as explicit insurance coverage (EC) expands at a constant level of credibility of non-insurance. As EC increases depositor monitoring declines and the ability of banks to shift risk to a deposit insurance fund or tax payers increases. Turning to the effects on risk-taking of implicit insurance, we assume that the extent of implicit insurance depends on the credibility of non-insurance and the share of deposits that are not covered by explicit insurance. The line denoted “Implicit” is drawn to show that the effect of implicit insurance on risk-taking declines as the explicit coverage increases and credibility of non-insurance increases. 7 Under reasonable assumptions vertical summation of the lines “Explicit” and “Implicit” gives us the U-shaped curve RT describing the relationship between risk-taking and explicit deposit insurance coverage. Important assumptions refer to diminishing returns with respect to reduced risk-taking as either explicit or implicit insurance is reduced from full insurance. In 6

The run on Northern Rock in the UK in the fall of 2007 indicates that the explicit deposit insurance coverage in the UK is not sufficient to prevent substantial bank runs. The UK deposit insurance system is also characterized by coinsurance. 7 The critical assumption for the line “Implicit” to be downward sloping in EC is that the effect on risk-taking incentives of the credibility effect dominates the effect of an increasing share of explicitly insured as EC increases (see Angkinand and Wihlborg, 2008)

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other words, a small group of depositors without explicit as well as implicit insurance has a relatively large effect on risk-taking incentives. 8 Although the U-shaped relationship described in Figure 1 constitutes one hypothesis to be tested below, it is clear that the U-shape is not a mathematical necessity. The stated assumptions provide sufficient but not necessary conditions. For example, if an increase in EC has little effect on the credibility of non-insurance while the direct effects of changes in EC on risk-taking incentives are strong the risk minimizing coverage would be zero. Another scenario is that the credibility of the explicit coverage depends negatively on the extent of this coverage. In this case, the line “Explicit” could be nearly flat and the costs in terms of risk-taking of increasing EC would be small. Under the same circumstances the line “Implicit” would most likely be flat as well. Explicit coverage would not matter much for risk-taking. Thus, a prerequisite for the analysis to be meaningful is that explicit coverage has reasonable credibility. We turn now to bank governance. The question asked is how the quality of governance in banks affects the relationship between explicit deposit insurance coverage (EC) and risktaking (RT). By high quality of governance we mean that the weight of shareholder’s wealth maximization in the objective of a bank’s management is high. The conflict of interest between shareholders and creditors of banks and the problem of excessive risk-taking depend on the governance structure of banks. In an efficient corporate governance system, shareholder’s wealth maximization will also lead to the maximization of creditors’ stake in a firm through the market discipline exerted by creditors. However, in the case of banks this market discipline is weak at very low or high levels of explicit deposit insurance coverage as described in Figure 1. High quality of bank governance implies that shareholders’ objectives have a large weight in managers’ incentives. Managers’ interest, on the other hand, can be assumed to be more oriented towards their own reputation and job security. It is safe to assume that there is a degree of stigma to being the manager of a failed bank. Therefore, managers can be expected to be less willing to take risk if their own interests weigh stronger than shareholders’ at any level of deposit insurance coverage. Accordingly, we expect that the relationship between EC and RT should be relatively flat if managers’ interests have strong weight relative to shareholder wealth maximization. 8

Formal conditions are shown in Angkinand and Wihlborg (2008).

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In Figure 1, shareholders prefer relatively high risk-taking at low and high levels of EC. Thus, we expect greater quality of governance from the point of view of shareholders to induce relatively more risk-taking at low and high levels of EC. At an intermediate level of EC, shareholders’ incentives to take risk are relatively weak as a result of market discipline exerted by creditors. Thus, higher quality of governance has relatively little effect on risk-taking in an intermediate range of EC. In this range, where market discipline on risk-taking is strong, shareholders might actually prefer less risk-taking than managers. Overall, higher quality of bank governance from a shareholder perspective is expected to lead to a more pronounced U-shape for the relationship between risk-taking and explicit deposit insurance coverage as described in Figure 2. We conclude this section by stating the hypotheses for the empirical analysis below 9: Hypothesis 1: Banks’ risk-taking (reflecting strength of moral hazard incentives) depends on the coverage of explicit deposit insurance schemes in such a way that risk-taking is relatively high for very low and very high levels of coverage, and minimized when there is positive but partial coverage when controlling for the capital ratio, macroeconomic factors, institutional factors affecting credibility of non-insurance and governance factors. This hypothesis is described in Figure 1 by the top dotted U-shaped curve. Hypothesis 2.a. Institutional and bank characteristics contributing to lower implicit insurance of banks’ creditors (higher credibility of non-insurance) improve market discipline and, therefore, a reduction in banks’ risk-taking caused by moral hazard incentives. This reduction in risk-taking is relatively large at low levels of explicit coverage of deposit insurance schemes. Furthermore, the minimum level of risk-taking occurs at a lower level of explicit coverage. This hypothesis is described by the shift down and to the left of the U-shaped dotted curve in Figure 1 as the arrow shows.. Hypothesis 2.b. A higher capital ratio reduces incentives for risk-shifting and weakens the relationship between deposit insurance coverage and risk-taking. Hypothesis 3: The relationship between explicit deposit insurance coverage and risk-taking is described by a flatter U-shaped curve for banks with relatively low quality of governance from shareholders’ point of view. Thus, we expect risk-taking to be higher at very low and very high levels of explicit coverage in banks with relatively high quality of governance. At intermediate 9

These hypotheses are tested on country level data in Angkinand and Wihlborg (2010).

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levels of explicit coverage where market discipline is potentially strong, we expect risk-taking to remain unchanged or even decrease with higher quality of bank governance. This hypothesis described in Figure 2 implies that governance variables interact with the variable describing explicit deposit insurance coverage to determine risk-taking incentives. The empirical specification allows for such interaction as well as independent effects of governance quality on risk-taking.

4. Model Specification and data. We test the above hypotheses with respect to effects of deposit insurance and bank governance on banks risk-taking using both panel and cross-sectional estimations. The three measures of risk-taking used in the analysis are the market z-score, the standard deviation of stock returns (Stock Volatility) and the ratio of bank non-performing loans relative to equity capital (NPL/CAP). 10 These variables are commonly used as proxies for risk-taking. The market z-score is employed as a proxy for “distance to default” defined as the sum of the average stock returns (based on the daily returns) over a year and the ratio of capital to total assets divided by the standard deviation of stock returns. 11 A higher value of Stock Volatility and NPL/CAP indicates increased risk taking while a higher value of the z-score corresponds to a lower probability of default or less risk taking. Descriptive statistics for these and other variables are reported in Table 1. Correlations among the variables are reported in Table 2. In the panel analysis, the estimation is based on the following specification: Risk j,i,t = α + δ1ECi,t −1 + δ2 (ECi,t −1 ) 2 + γGovernance j,i + βBank j,t −1 +ωMacro / Institution i,t −1 + τCountryi + φYeart + ε j,i,t where Riskj,i,t is one of three proxies for risk taking in bank j in country i and year t. EC is the explicit coverage of deposit insurance (EC), which is entered in the quadratic functional form (proxies of EC are discussed below). Hypothesis 1 referring to a U-shaped relationship between risk-taking and the degree of explicit protection is supported if the estimated coefficient

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In regressions, the market z-score and NPL/CAP are in natural logarithm. An alternative proxy for incentive effects of deposit insurance is the The Implicit Insurance Premium (IPP) representing an implicit premium on a put option on a bank’s assets. IPPs for banks in a number of countries have been estimated by Hovakimian et al (2003). We do not use this proxy because it depends not only on the probability of exhausting equity capital at a point in time but also on expected government support to shareholders or costs imposed on shareholders when a bank approaches distress (Pennacchi,1987). Our hypotheses are based on the assumption that risk-taking at any time is equivalent to the probability of exhausting the current equity capital.

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for the squared term (δ2) is positive and significant, and if the estimated coefficient for the linear term (δ1) is negative and significant. Reduced implicit creditor protection caused by increasing explicit coverage is captured by the downward sloping part of the quadratic function. Proxies for implicit creditor protection caused by “too big to fail” are introduced as well among the bank-specific variables in order to test Hypothesis 2. Two proxies are the share of each bank’s deposits in total deposits in the country and size. We expect that a relatively large bank is more likely to be “too big to fail” and be bailed out in a distress. If these variables fully capture implicit creditor protection the relationship between deposit insurance coverage will be dominated by the upward sloping line “Explicit” in Figure 1. However, we do not expect the “too big to fail” proxy to fully capture the extent of implicit insurance and its relation with explicit insurance. In order to test Hypothesis 3 with respect to quality of bank governance, proxies for governance quality are allowed to interact with the quadratic term for explicit deposit insurance coverage (i.e. EC2i × Governancej,i). 12 Governancej,t is a vector of bank-specific governance variables. They are described below. A number of bank and country characteristics are introduced in the estimations as control variables. Bank j,t is a vector of bank-specific control variables such as the cost/income ratio, the bank beta and the deposit/asset ratio. Macro/Institutioni,t is a vector of control variables for country characteristics including both macroeconomic variables and variables capturing quality of domestic institutions. 13 A set of these control variables is shown in Table 1. To reduce a potential simultaneity bias between risk-taking and deposit insurance, in particular, the mentioned independent variables are lagged one year. Another reason for the one year lag is that the risk-taking proxies are not ex ante measures of risk but the result of risktaking decisions made prior to the observations of risk. In the panel estimations, we include both the country- and year-fixed effects. Country i is a vector of country-specific dummy variables, and Yeart is a vector of time-specific dummies included to control for aggregate shocks. We do not introduce bank-specific dummies since our

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The governance variable interacting with the squared covdepint contributes to a flatter relationship between covdepint and risk-taking if the coefficient for the interactive variable has the opposite sign relative to the coefficient for (covdepint × covdepint) alone. 13 GDP/capita reflects the general institutional quality in a country. In AW (2006) Rule of Law and (Lack of) Corruption were used as alternative proxies.

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bank governance data is cross-sectional variables, i.e. one observation per bank, and the timeinvariant bank governance variables cannot be used with fixed-effect models. However, included bank governance variables should capture and control for bank-specific characteristics. 14 The cross-section analysis uses the same model specification except that annual observations are averaged over the estimation period and dummies for country and year effects are excluded. 15 Turning to data sources balance sheet and income statement data from 1996 are obtained from the BankScope database. The data for daily stock prices are taken from Datastream. The sample of banks is limited to publicly traded banks because we use market data for two risk measures. Furthermore, important governance variables are available only for these banks. We collect seven bank-specific governance variables from the Reuters database 16 for a sample of industrial and emerging market economies. These data are available for 482 banks. After taking into account the missing observations for other bank-specific and control variables, the data set covers 284 banks in 39 countries of which 11 are industrial and 28 emerging market countries for the period 1996-2003. 17 (To be updated through 2007) Since the correlations among some of the bank governance variables are relatively high, we include two variables which capture bank ownership structure and two variables that capture bank ownership concentration in our estimations. For bank ownership structure, Govt-Owned Bank is defined as the percent of equity owned by the government or state when the largest shareholder is the state. Foreign-Owned Bank is a dummy variable with the value equal to 1 when the largest owner is a foreign block-holder. For bank ownership concentration, Institutional Ownership is defined by the percent of equity held by institutional owners excluding mutual funds and other pure portfolio investors. Ownership concentration (or 3 Largest Shareholders) is

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In the robustness check [not yet included], we will replace country dummies with the country-level governance variables, including for example shareholder rights and creditor rights. These variables are time-invariant; therefore, we use a simple time-series cross-section (pooled) regressions rather than country-fixed effect models. 15 In the robustness check [not yet included], we will perform additional tests by using the beginning-period of control variables and two-stage least squares to check whether the results are driven by simultaneity bias. 16 These seven variables are 1) % ownership by largest stakeholders, 2) % ownership by three largest stakeholders, 3) total % ownership share of all stakeholders , 4) total % ownership share of all institutional owners, 5) foreign ownership of banks, 6) government ownership of banks and 7) category of largest stakeholders (e.g. public, private, individual, pension fund, etc). 17 We do not include developing countries in the analysis due to the lack of bank corporate governance variables.

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defined as the share of equity held by the three largest owners.

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The latest data for these

variables have been used. Thus, there is no time variation in these data. (Only concentration varaible is included so far) Proxies for deposit insurance coverage are based on data for deposit insurance systems worldwide in the Database of Deposit Insurance Around the World published by Demirgüç-Kunt et al. (2005), at the World Bank. The deposit insurance variable in the baseline model is the coverage limit divided by per capita deposit (coverage per average deposit), or Covdep. Coverage limit is the maximum coverage per deposit account within each deposit insurance system. The time coverage in our estimation is limited to 2003 since the Covdep data is available up to 2003. As an alternative to the country-fixed effects model we introduce country-specific governance variables including stakeholder rights, market monitoring and regulation. These variables are time-invariant; therefore, they cannot be used with country dummies. Instead, they should capture the difference in a country-level effectiveness of legal system and governance. Shareholder Rights and Creditor Rights data are those of La Porta et al. (1998). The index of shareholder rights ranges from 0 to 6 with a higher value reflecting stronger protection of minority shareholders against managers or dominant shareholders. The index of creditor rights range from 0 to 4 with a higher value reflecting greater protection of secured creditors in particular. A variable measuring banks’ transparency and disclosure is called the Private Monitoring Index. 19 The first group captures the general institutional quality of each country. As mentioned, this group includes only Real GDP per Capita in this paper. As noted in La Porta et al. (1998, 2002), poorer countries generally have weaker governance structures. (So far only GDP/Capita is included in the regressions below) Definitions of all variables used in the analysis are presented in Data Appendix. Descriptive statistics of these variables are reported in Table 1. The correlations among variables are reported in Table 2.

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Two additional governance variables from Reuters that we consider are the percent of ownership by largest stakeholder/insider (Largest shareholders) and the total percent of ownership share of all stakeholders and insiders (Stake/Insiders-Owned). These two variables are highly correlated with 3 Largest Shareholders(see Table 2); therefore, we do not present the results here. 19 AW (2006) consider legal regimes as well but they have very little explanatory power for risk-taking in country analysis. That Paper also includes the quality of financial supervision using data for prompt corrective action procedures (PCA) from the database presented in Barth et al. (2006)

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5. Empirical analysis of banks’ risk-taking Before presenting results of the empirical analysis the development of banks’ risk-taking in different regions of the world are shown in Figure 3 for the period 2000-2008. Averages of banks’ market z-scores in the US, UK, Higher income Asia and Lower income Asia are shown. The US z-scores are the highest for the whole period and they are declining except between 2001 and 2002. Thus, the riskiness of US banks seem to have been increasing during the period. The z-scores for banks in both the Asian groups have been increasing until 2007 when the financial crisis was in its initial phase in the US. Z-scores in the UK started to fall slowly in 2004. As measured by z-scores, the riskiness of banks in all countries increased from 2007 to 2008. The market z-scores for the 20 largest banks in the world in 2008 are shown in Table 3. Two Japanese banks are the 2nd, the 7th and the 8th riskiest banks according to the z-scores in the table. Royal bank of Scotland has the lowest z-score and Citigroup has the 3rd lowest score. Two lower income Asian banks in China are the 17th and the 18th riskiest with z-scores above major US banks such as J.P. Morgan and Bank of America. Regression results for z-scores and the other risk proxies are presented in Tables 4-9. The estimation period is 1996-2003 (to be updated through 2007). Column 1 in all tables refers to results for the natural log of Market z-scores in panel regressions and Column 2 shows the results of cross-section analysis of the same variable, Results in Column 3 show results for Stock Volatility panel regressions. The difference between z-scores and stock volatility is that stock volatility captures only asset side risk while z-scores incorporate both leverage and the average return on assets. Column 4 shows the results for panel regressions using non-performing loans relative to equity capital (NPL/Cap) as the dependent variable. This variable has been commonly used as a proxy for risk-taking based on the assumption that observed NPL in a particular period reflect expected loan losses in the previous period for a given probability distribution. We use the natural log of this variable and the z-score to reduce the weight of relatively extreme values. If capital is low, extreme values are likely to exist. Tables 4-6 do not include interaction terms which are introduced in Tables 7-9. Tables 4 and 7 present results for all the 39 countries. The sample in Tables 5 (6) and 8 (9) are banks in 11 (28) industrialized (emerging market) countries. A first result in Tables 4-6 is that there is support for Hypothesis 1 stating that there is a partial level of deposit insurance coverage that minimizes risk-taking. The coefficient for the

16

linear Covdepint term is positive in the z-score regressions and negative in the Stock Volatility and the NPL/Cap regressions while the coefficient for the squared Covdepint term is negative in the Z-score regressions and positive in the Stock Volatility and NPL/Cap regressions in the three tables. All these signs are consistent with the hypothesis. All the coefficients are not significant, however. In particular, the coefficients are not significant in the z-score panel regressions and the emerging market regressions. In Tables 7-9 where interactions between governance variables and Covdepint squared are included, the squared term is significant in z-score panel regressions indicating that the relationship between deposit insurance coverage and risk-taking depends on governance variables and the capital ratio as suggested in Hypotheses 2 and 3. We return to these results below. Among the bank-specific variables in Tables 4-7 the capital ratio (CAP/TA) is significant in all regressions and the signs indicate that an increased capital ratio reduces risk-taking including risk on the asset side captured by Stock Volatility. Ownership concentration captured by 3 Largest Shareholders seems to increase risk as measured by the z-score, in particular, in industrialized countries but reduce risk in emerging market countries. Foreign ownership as well as government ownership contributes to increased risk-taking in emerging markets in particular. The share of liquid assets (Liquid Asset/TA) seems to be associated mainly with the NPL/Cap measure of risk and in this case with reduced risk. The Cost/Income ratio is generally associated with increased risk. The Deposit Share and the Total Assets variables are expected to capture implicit insurance associated with “too big to fail.” Both variables are significant in all regression for all countries in Table 4. The deposit share is associated with reduced risk except in the NPL/Cap regression where the coefficient is positive and strongly significant. Total assets are associated with lower z-scores as expected but with lower stock volatility and NPL/Cap. Thus the results with respect to “too big to fail” are ambiguous. The beta (relative to a world market portfolio) is generally significant and associated with higher risk-taking. Thus, banks that offer little portfolio diversification are also banks with higher likelihood of distress. GDP/capita is introduced as a proxy for general institutional quality. This variable is expected to be negatively associated with risk. The signs are generally consistent with this hypothesis but they are not always significant.

17

The last group of variables (GDP Growth, Inflation and Real Int. Rate) control for macroeconomic conditions in each country. The signs and significance show no obvious pattern. We turn next to the results for interaction variables in Tables 7-9 in order to evaluate Hypotheses 2.a, 2.b, and 3. The squared term for deposit insurance coverage (covdepint_sq.) is allowed to interact with the capital ratio (Capital/TA), ownership concentration (3 Largest shareholders), the share of foreign ownership (Foreign-Owned) and state control (Govt-Owned). It is expected that a higher capital ratio is associated with reduced moral hazard. Accordingly, the sign for the interaction term should be the positive in the z-score regressions and negative in the other regressions indicating reduced moral hazard as the capital ratio increases. The coefficients in Columns 1 and 2 for the z-score regressions in the three tables are all positive as expected and significant. The coefficients for the same interaction term in the Stock Volatility and the NPL/Cap regressions are not significant in Table 7 for all countries but negative as expected and significant for industrialized countries in Table 8. The corresponding coefficients are insignificant for emerging market countries. Overall, the results support the hypothesis that moral hazard incentives are reduced in banks with relatively high capital ratios. Shareholder concentration is expected to increase the quality of corporate governance in the sense that manager’s interests are aligned with shareholders. The negative, significant coefficients for the interaction between 3 Largest Shareholders and Covdepint_sq in the panel zscore regressions in Table 7, in both z-score regressions for industrialized countries in Table 8 indicate that shareholder concentration is associated with relatively high risk-taking in countries with high deposit insurance coverage. The positive coefficients for the same interaction term in the Stock Volatility and the NPL/Cap regressions strengthen this result for industrialized countries. Results for emerging market countries are ambiguous with respect to the role of shareholder concentration. The results with respect to the interaction between foreign ownership and covdepint_sq are also ambiguous. This interaction term is most significant for emerging market economies. The signs indicate that higher foreign ownership is associated with higher risk-taking at relatively high levels of explicit deposit insurance coverage. State control seems to have the strongest effect on risk-taking incentives associated with the level of deposit insurance in industrialized countries in Table 8. The results in this table as well as in Table 7 are mostly consistent with a U-shaped relationship between deposit insurance

18

coverage and risk-taking although the coefficients are not consistently significant. The coefficient for Govt-Owned interacting with Covdepint_sq is generally the opposite of the sign for Covdepint_sq alone indicating that government ownership is associated with less sensitivity of risk-taking incentives to deposit insurance coverage as Hypothesis 3 suggests. State ownership with zero deposit insurance coverage seems to be associated with increased risk-taking. Since the curvature of the relationship between deposit insurance coverage and risktaking is not easily inferred from the regression coefficients, we plot in Figure 4 the curvature implied by the regression results for NPL/Cap for industrialized countries in Table 8, Column 4. The curvature is shown for the lowest and the highest values of foreign ownership in Figure 4 a and for the lowest and the highest values of ownership concentration in Figure 4 b. Average values of all other variables are used to calculate the NPL/Cap at different values for covdepint, Foreign-Owned and 3 largest Shareholders. The U-shaped relationship is evident in both Figures 4 a and b but the impact on risk of implicit insurance (associated with low explicit deposit insurance) appears much stronger than the impact of high explicit insurance per se. In Figure 4 a high foreign ownership is associated with higher risk at high levels of implicit insurance (low levels of explicit insurance), in particular. In Figure 4 b high ownership concentration is associated with greater risk-taking and a more pronounced U-shape as expected if ownership concentration leads to stronger alignment of managers’ and shareholders interest.

(Figures for z-scores should be constructed)

6. Conclusions Using bank level data from 39 countries we find evidence of a U-shaped relationship between risk-taking and deposit insurance coverage, reflecting that strong implicit insurance is associated with low explicit coverage. Evidence of implicit insurance associated with the size of a bank or the market share of a bank is weaker. We focused the analysis on bank-specific governance and ownership variables and their interaction with risk-taking incentives created by implicit and explicit depositor protection. The main governance variables, ownership concentration, foreign ownership and state control are not unambiguously related to quality of governance from a shareholder perspective. Testing the

19

hypothesis with respect to the impact of quality of governance therefore implies testing of a joint hypothesis with respect to the relationship between our governance variables and the quality of governance, and the relationship between quality of governance and risk-taking behavior at different levels of explicit deposit insurance coverage. The results with respect to the impact on risk-taking of ownership variables are generally sensible; ownership concentration seems to be associated with greater risk at low levels of explicit deposit insurance coverage (strong implicit insurance) in particular. State control is associated with relatively high risk-taking in industrialized countries, in particular, and the effect of deposit insurance coverage on risk-taking incentives seems to be weakened by state control. Foreign ownership on the other hand seems to affect risk taking the most in emerging market economies. Higher foreign ownership is associated with more risk-taking at low levels of deposit insurance coverage in particular in these countries.

20

Data Appendix: Data descriptions and sources Variable

Description

Source

Dependent Variables (The bank-specific proxies of risk taking) Stock Volatility

The standard deviation of daily stock market price returns

Bankscope

NPL/CAP

The ratio of non-performing loans (NPL) to total capital (total capital = retain earning+common share+preference shares)

Bankscope

Market z-score

Bank’s z-score based on market data defined as (average stock returns + equity/total assets) relative to the standard deviation of stock returns. Avrage stock returns are based on the daily returns.

Bankscope Datastream

Independent Variables Deposit Insurance Variables Covdepint (Coverage Limit Per Deposit Per Capita—Interval)

Covdepint_sq

The interval data of the ratio of deposit insurance coverage per deposits per capita. The value of this variable is assigned based on a value of the coverage to deposits per capita. This variable = 0 if there is no explicit deposit insurance coverage, 1 if the coverage to deposit per capita ratio (covdep) is between (0,1), 2 if covdep is between [1,2), 3 if covdep is between [2,3), 4 if covdep is between [3,5), 5 if covdep is between [5,10), 6 if covdep is between [10,15), 7 if covdep is between [15,20), 8 if covdep is between [20,50), 9 if covdep is greater than 50, and 10 for the full coverage.

Authors’ construction Coverage limit to deposit per capital is from Demirgüç-Kunt et al. (2005)

The squared term of Covdepint

Bank Corporate Governance Variables 3 largest shareholders

% sum of three largest shareholder/institution owners

Reuters

Govt-Owned

% held by government if government = stakeholder

Reuters

Foreign-Owned

The dummy variable of foreign ownership of bank. This dummy has a value of 1 if the largest ownership is foreign and 0 otherwise.

Reuters

Bank Specific Variables Capital/TA Liquid Asset/TA

The ratio of capital/total assets (Capital = retain earning+common share+preference shares) The ratio of liquid asset/total assets

Cost/Income

The ratio of cost to income

Bankscope

Deposit Share

The ratio of total deposits of each bank to total deposits of all banks in country i

Bankscope

Market beta

Stock market beta

Bankscope

Bankscope Bankscope

Country Specific Variables GDP/Cap

Real GDP per capita (constant 2000 US$).

WDI

GDP Growth

Real GDP growth (annual %)

WDI

Inflation

Inflation, consumer prices (annual %)

WDI

Real interest rate

Real interest rate (%)

WDI

21

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Cull, Robert, Lemma W. Senbet, and Marco Sorge (2005). “Deposit Insurance and Financial Development”, Journal of Money, Credit, and Banking,37(1); 43-82 Demirgüç-Kunt, Asli and Enrica Detragiache (1997). “The Determinants of Banking Crises: Evidence from Developing and Developed Countries”, IMF Working Paper No. 106 International Monetary Fund: Washington, D.C. Demirgüç-Kunt, Asli and Enrica Detragiache (2002). “Does Deposit Insurance Increase Banking system Stability? An Empirical Investigation”, Journal of Monetary Economics 49; 13731406. Demirgüç-Kunt, Asli and Harry Huizinga (2004). “Market Discipline and Deposit Insurance.” Journal of Monetary Economics, 51, 375-399. Demirgüç-Kunt, Asli, Karacaovali and L. Laeven (2005). “Deposit insurance around the World: A comprehensive database”, World Bank Policy Research Working Paper, Washington, DC. Demirgüç-Kunt, Asli, Ross Levine, and Hong-Ghi Min (1998) “Opening to Foreign Banks: Stability, Efficiency and Growth”, in The Implications of Globalization Financial Markets, ed. by A. Meltzer (Korea: Bank of Korea). Distinguin, Isabelle, Philippe Rous and Amine Tarazi (2005), “Market Discipline and the Use of Stock Market Data to Predict Financial Distress” Working paper, University of Limoges. Eichengreen, Barry and Carlos Arteta (2002) “Banking Crises in Emerging Markets: Presumptions and Evidence” in Mario I. Blejer and Marko Skreb (eds) Financial Policies in Emerging Markets. Cambridge, Mass.: MIT Press. Fernandez, Ana and Francisco Gonzalez (2005) “How accounting and auditing systems can counteract risk-shifting of safety-nets in banking: Some international evidence”, Journal of Financial Stability, 1(4), 466-500 Gonzales, Francisco (2005), “Bank Regulation and Risk-taking Incentives: An International Comparison of Bank Risk”, Journal of Banking and Finance, 29, Nr 5, May, pp 1153-84 Gropp, Reint and Jukka Vesala (2004), “Deposit Insurance, Moral Hazard and Market Monitoring”, Review of Finance, 8, 571-602. Hoggarth, Glenn, Patricia Jackson, and Erlend Nier (2005) “Banking Crises and the Design of Safety Nets”, Journal of Banking & Finance, 29; 143-159. Hovakimian, A., Edward Kane, and Luc Laeven (2003), “How Country and Safety-Net Characteristics Affect Bank Risk Shifting”, Journal of Financial Services Research, 23(3),177-204. Hutchison, Michael and Kathleen McDill (1999) “Are All Banking Crises Alike? The Japanese Experience in International Comparison”, Journal of the Japanese and International Economics, 13; 155-180. Kane, Edward J. (2000),”Designing Financial Safety Nets to Fit Country Circumstances”, Policy Research Working Paper 2453, The World Bank, Washington D.C.

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Jagtiani, Julapa, George Kaufman, and Catharine Lemieux (2002), “The Effect of Credit Risk on Bank and Bank Holding Company Bond Yields: Evidence from the Post-FDICIA Period”, Journal of Financial Services Research, 25 (4), Dec. p 559. La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny (1998). “Law and Finance”, The Journal of Political Economy, Vol. 106, No.6. La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny (2002). “Government Ownership of Banks”, The Journal of Finance, Vol. LVII, No.1 February. Lensink, Robert and Niels Hermes (2006), “The Short-term Effects of Foreign Bank Entry on Domestic Bank Behavior. Does Economic Development Matter?” Journal of Banking and Finance, Forthcoming Lensink, R. and I. Naaborg (2006), “Banking in Transition Economies: A Study of Foreign Ownership and Performance”, European Journal of Finance, Forthcoming. Levine, Ross (2004) “Denying Foreign Bank Entry: Implications for Bank Interest Margins” in Banking Market Structure and Monetary Policy by Luis Antonio Ahumada and J. Rodrigo Fuentes (eds), Santiago, Central Bank of Chile. Miller, Geoffrey P. (1998), “On the Obsolescence of Commercial Banking” Journal of Institutional and Theoretical Economics, 154(1), 61-65 Nier, Erlend and Baumann, Ursel (2006). “Market Discipline, Disclosure and Moral Hazard in Banking”, Journal of Financial Intermediation, 15; 332–361 Pennacchi, G.G. (1987), A Reexamination of the Over-(or Under-) Pricing of Deposit Insurance”, Journal of Money, Credit and Banking, 19 (3), 340-360 Pistor, Katharina, Martin Raiser, and Stanislaw Gelfer (2000) “Law and Finance in Transition Economies”, Economics of Transition, Vol. 8, pp. 325-368. Saunders, Anthony, Elizabeth Strock, and Nickolaos G. Travlos (1990), “Ownership Structure, Deregulation, and Bank Risk Taking”, The Journal of Finance, XLV(2), June, 643-654. Sironi, A. (2000), “Testing for Market Discipline in the European Banking Industry: Evidence from Subordinated Debt Issues” Working Paper, Bocconi University, Milan. Tadesse, Solomon (2005) “Banking Fragility and Disclosure: International Evidence”, Working Paper no. 748, William Davidson Institute at the University of Michigan Stephen M. Ross Business School in its series.

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Figure 1 Hypothesized relationships between explicit deposit insurance coverage (EC) and risktaking (RT) and the impact of institutional and banks’ ownership variables.

RT Explicit

Implicit Implicit × Institution

EC This figure shows the relationship between bank’s excessive risk-taking (RT) and explicit deposit insurance coverage (EC). The line “Explicit” is drawn at a constant degree of credibility of non-insurance; an upward slope reflects the moral hazard incentives become stronger at high levels of EC. The line “Implicit” is drawn at a constant level of risk taking caused by explicit deposit insurance coverage; a negative slope shows how RT caused by implicit insurance decline with increasing EC as a result of credibility of non-insurance (CNI). The two lines are added vertically. The total effect of EC on risk taking is shown as a U-shaped curve. The line Implicit × Institution shows how the curve Implicit shifts as a result of better quality of institutions (and bank ownerships and financial supervisions) enhancing the CNI. The top dotted line is the vertical sum of Explicit and Implicit. The lower dotted line is the vertical sum of Explicit and Implicit × Institution.

Figure 2 The U-shape relationship and the impact of bank governance RT

Good governance Weak governance

EC

“Good” governance implies that shareholders’ objectives have a large weight in managers’ incentives.

25

Figure 3 Banks’ market z-score in selected countries and country groups during 2000-2008

70

Higher income Asia

Lower-income Asia

United States

United Kingdom

60 50 40 30 20 10 0 2000

2001

2002

2003

2004

2005

2006

2007

2008

Note: only banks with total assets greater than US$ 100 million are included. Higher income Asian countries include Hong Kong, Japan, South Korea, Singapore and Taiwan. Lower income Asian countries include China, India, Indonesia, Malaysia, the Philippines and Thailand

26

Figure 4 Risk taking at different levels of deposit insurance coverage and corporate governance Figures below plot the predicted values of NPL/CAP at different levels of coverage limit of deposit per capita (covdepint). These predicted values are calculated by using the minimum and maximum values of bank governance variables and using the mean values of other independent variables. Both figures 4a and 4b use the values from regression in column 4 Table 8, for the sample of industrial countries.

4.a risk taking and explicit deposit insurance at different levels of foreign ownership of banks

Predicted NPL/Capital

3 2.5 2 1.5 1 0.5 0 0

1

2

3

4 5 6 Covdepint (t-1)

7

8

9

10

foreign-Owned =1

Foreign-Owned =0

4.b risk taking and explicit deposit insurance at different levels of bank concentration (measured by the percent of shares held by three largest shareholders)

Predicted NPL/Cap

6 5 4 3 2 1 0 0

1

2

3

4 5 6 Covdepint (t-1)

concentration = MIN

27

7

8

9

concentration = MAX

10

Table 1. Descriptive Statistics (incomplete) Variable

Obs

Mean

Std.

Min

Max

Dependent Variables: Risk-Taking NPL/CAP Volatility of Stock Price STDNPL/CAP STDCAP/CAP

2405 1305 504 638

0.832 1.189 0.313 0.289

1.244 3.733 0.670 0.176

0 0 0 0.020

20.631 65.334 8.200 1.071

Control Variables Covdepint t-1 Covdepintsq t-1 Liquid Asset/TA NIM Capital/TA Cost/Income Deposit Share GDP/Cap Growth GDPt-1 Inflation t-1 Real Interest Rate t-1

2405 2405 2405 2405 2405 2405 2405 2405 2405 2405 2405

5.767 45.098 0.258 4.632 8.506 65.867 0.059 16.786 1.373 4.693 7.208

3.442 38.896 0.195 5.260 7.047 25.451 0.114 15.300 3.190 8.690 8.752

0 0 0.007 -6 0.610 7.350 1.8E-06 0.352 -14.296 -3.947 -45.521

10 100 0.910 57.1 97.820 394.050 1 38.2004 23.2612 140.08 70.7445

1129 1129 1129 1129 1129 1129 1129

0.291 0.077 0.038 0.090 0.088 0.038 0.024

0.282 0.267 0.136 0.142 0.877 0.962 1.020

0 0 0 0 0.07 0.01 0

0.997 1 0.750 0.958 0.11 0.05 0.04

Corporate Governance 3 largest shareholders Foreign-Owned Govt-Owned Institution-Owned Private Monitoring Shareholder Rights Creditor Rights

28

Table 2. Correlation Matrices (Incomplete) Dependent Variables (Proxies of Risk Taking) NPL/Cap ln(NPL/Cap)

0.74

Volatility of Stock Price

-0.14

Volatility of Stock Price 1

Corporate Governance

Largest shareholders

3 Largest Shareholders

Largest shareholders

0.96

1

Stake/Insider s-Owned

InstitutionOwned

ForeignOwned

Govt-Owned

Private Monitoring

Shareholder Rights

Stake/Insiders-Owned

0.93

0.91

1

Institution-Owned

-0.09

-0.20

-0.30

Foreign-Owned

-0.20

-0.20

-0.27

0.13

1

Govt-Owned

0.32

0.30

0.27

-0.02

-0.08

1

Private Monitoring

-0.26

-0.29

-0.25

0.38

-0.05

-0.32

Shareholder Rights

-0.14

-0.13

-0.13

0.16

-0.07

0.08

0.02

1

Creditor Rights

0.03

0.04

-0.05

-0.15

0.10

0.29

-0.59

-0.05

1

1

Table 3 The market z-score of 20 largest banks in the world in 2008 Bank name Royal Bank of Scotland Group Plc Mizuho Financial Group Citigroup Inc UBS AG Deutsche Bank AG ING Groep NV Sumitomo Mitsui Financial Group, Inc Mitsubishi UFJ Financial Group Inc HSBC Holdings Plc Wells Fargo & Company Société Générale BNP Paribas JP Morgan Chase & Co. Bank of America Corporation Barclays Plc Crédit Agricole S.A. China Construction Bank Corporation The Industrial & Commercial Bank of China Banco Santander SA UniCredit SpA

Country name United Kingdom Japan USA Switzerland Germany Netherlands Japan Japan United Kingdom USA France France USA USA United Kingdom France China China Spain Italy

Source: BankScope, 2009.

30

Total assets (US$ billions) 3,501 1,517 1,938 1,894 3,065 1,853 1,180 1,930 2,527 1,310 1,573 2,889 2,175 1,818 2,993 2,301 1,105 1,428 1,461 1,455

Market zscore 3.18 3.31 4.51 4.61 4.98 7.86 8.96 9.04 12.55 13.46 15.03 15.98 18.10 18.42 20.86 21.01 21.29 26.04 35.60 36.01

Table 4 The effect of DI coverage and corporate governance on banks’ risk-taking Sample: all countries; 1996-2003 (1)

(2)

(3)

(4)

Dependent variable

Market z-score

Market z-score

Stock Volatility

NPL/Cap

Method

Panel

Cross-Section

Panel

Panel

0.179 (0.627)

0.063* (0.081)

-0.019** (0.004)

-0.804# (0.206)

-0.033 (0.579)

-0.022** (0.001)

0.003** (0.003)

0.130# (0.205)

Capital/TA

5.348** (0.000)

5.083** (0.000)

-0.010** (0.038)

-9.028** (0.000)

3 Largest Shareholders

-0.150* (0.054)

-0.174** (0.014)

0.002# (0.204)

-0.016 (0.897)

Foreign-Owned

-0.081# (0.225)

-0.276** (0.000)

0.003** (0.024)

0.163# (0.107)

Govt-Owned

-0.056 (0.651)

-0.275** (0.003)

0.001 (0.805)

0.321* (0.077)

Liquid Asset/TA

0.127 (0.470)

0.117 (0.431)

-0.003 (0.414)

-1.561** (0.000)

Cost/Income

-0.222** (0.002)

-0.371** (0.000)

0.003** (0.005)

-0.178# (0.103)

Deposit Share

1.248** (0.000)

2.056** (0.000)

-0.023** (0.000)

3.012** (0.000)

Total assets

-0.039** (0.034)

-0.124** (0.000)

-0.001** (0.019)

-0.181** (0.000)

Market beta

-0.356** (0.000)

-0.429** (0.000)

0.008** (0.000)

0.167** (0.032)

GDP/Cap t-1

0.663# (0.208)

0.182** (0.000)

-0.021** (0.025)

-2.267** (0.007)

GDP Growth t-1

-1.401# (0.101)

-1.189* (0.073)

-0.006 (0.713)

-0.283 (0.824)

Inflation t-1

0.417 (0.557)

-0.033 (0.951)

-0.005 (0.717)

0.153 (0.880)

Real Int Rate t-1

0.240 (0.643)

0.092 (0.672)

0.013# (0.171)

-1.394# (0.154)

Constant

0.115 (0.000)

2.820** (0.000)

0.098** (0.000)

9.309** (0.000)

Within R2

0.272

0.544

0.108

0.211

No. of Obs

1379

307

1390

1174

F-Statistics

24.992

95.508

9.946

17.525

Prob(F-Stat>0)

0.000

0.000

0.000

0.000

Covdepint t-1 Covdepint_sq

t-1

Risk-taking is proxied by the natural log of the market z-score, the standard deviation of stock market returns (stock volatility), and the natural log of NPL/CAP. The panel regressions are estimated using the country- and year- fixed effects. *, ** indicate the significance levels of 10%, and 5% respectively. # indicates the coefficient value zero that falls outside one standard deviation of the estimate. The numbers in parentheses are p-values.

Table 5 The effect of DI coverage and corporate governance on banks’ risk-taking Sample: Industrialized countries; 1996-2003

(1)

(2)

(3)

(4)

Dependent variable

Market z-score

Market z-score

Stock Volatility

NPL/Cap

Method

Panel

Cross-Section

Panel

Panel

0.715 (0.602) -0.109 (0.626) 4.941** (0.000) -0.616** (0.000) -0.013 (0.894) 3.402** (0.000) -0.089 (0.754) 0.263* (0.099) 1.213** (0.034) -0.053** (0.034) -0.449** (0.000) 2.904# (0.251) 2.983 (0.326) -5.109# (0.209) 0.581 (0.878) -8.732 (0.348) 0.319 809 19.534

0.054 (0.656) -0.035# (0.158) 5.127** (0.000) -0.238# (0.103) -0.362* (0.085) -0.678** (0.045) 0.867** (0.000) -0.196 (0.523) 0.329# (0.291) -0.011 (0.676) -0.872** (0.000) 0.255# (0.252) -6.083 (0.368) 16.110* (0.085) -6.598** (0.008) 1.253# (0.239) 0.638 162

-0.030# (0.143) 0.005# (0.152) -0.011** (0.042) 0.006** (0.002) 0.004** (0.008) -0.047** (0.001) 0.009** (0.027) 0.000 (0.956) -0.021** (0.013) 0.000 (0.527) 0.008** (0.000) -0.037 (0.329) -0.057# (0.205) 0.133** (0.028) 0.016 (0.773) 0.171# (0.218) 0.136 812 7.566

-4.482** (0.020) 0.728** (0.020) -15.118** (0.000) 0.044 (0.791) -0.198* (0.091) 1.268 (0.332) -1.452** (0.000) -1.179** (0.000) 3.930** (0.000) -0.203** (0.000) -0.136# (0.218) -5.078# (0.155) 2.192 (0.551) -12.274** (0.015) -0.95 (0.839) 25.988** (0.049) 0.326 715 17.865

Covdepint t-1 Covdepint_sq t-1 Capital/TA 3 Largest Shareholders Foreign-Owned Govt-Owned Liquid Asset/TA Cost/Income Deposit Share Total assets Market beta GDP/Cap t-1 GDP Growth t-1 Inflation t-1 Real Int Rate t-1 Constant Within R2 No. of Obs F-Statistics

53.012

Prob(F-Stat>0) 0.000 0.000 0.000 0.000 Risk-taking is proxied by the natural log of the market z-score, the standard deviation of stock market returns (stock volatility), and the natural log of NPL/CAP. The panel regressions are estimated using the country- and year- fixed effects. *, ** indicate the significance levels of 10%, and 5% respectively. # indicates the coefficient value zero that falls outside one standard deviation of the estimate. The numbers in parentheses are p-values.

Table 6 The effect of DI coverage and corporate governance on banks’ risk-taking Sample: Emerging market economies; 1996-2003 (1)

(2)

(3)

(4)

Dependent variable

Market z-score

Market z-score

Stock Volatility

NPL/Cap

Method

Panel

Cross-Section

Panel

Panel

Covdepint t-1

-0.024 0.093 -0.008 -0.007 (0.634) (0.821) (0.404) (0.994) Covdepint_sq t-1 -0.005 -0.031 0.002# 0.024 (0.559) (0.611) (0.196) (0.852) Capital/TA 6.545** 6.227** -0.013# -6.077** (0.000) (0.000) (0.223) (0.000) 3 Largest Shareholders 0.286** 0.155# 0.000 0.001 (0.000) (0.106) (0.887) (0.995) Foreign-Owned -0.111# -0.118# 0.003# 0.543** (0.181) (0.179) (0.189) (0.004) Govt-Owned -0.626** -0.402** 0.006** 0.367* (0.000) (0.000) (0.036) (0.085) Liquid Asset/TA 0.047 -0.041 -0.007# -1.840** (0.759) (0.837) (0.158) (0.000) Cost/Income -0.242** -0.234** 0.003* 0.099 (0.002) (0.001) (0.058) (0.458) Deposit Share 1.799** -0.06 -0.005 1.665** (0.000) (0.878) (0.634) (0.040) Total assets 0.013 0.124** -0.003** -0.041 (0.559) (0.000) (0.000) (0.558) Market beta -0.323** -0.123* 0.007** 0.317** (0.000) (0.055) (0.000) (0.012) GDP/Cap t-1 0.044* -0.421 -0.007 -1.587# (0.090) (0.453) (0.617) (0.150) GDP Growth t-1 -1.203* -0.719 -0.011 -1.037 (0.081) (0.379) (0.584) (0.517) Inflation t-1 -0.619# 0.094 -0.004 0.575 (0.245) (0.892) (0.816) (0.656) Real Int Rate t-1 -0.179 -0.100 0.016# -1.558# (0.324) (0.834) (0.182) (0.180) Constant 0.525# -0.442 0.084** 2.005# (0.138) (0.617) (0.000) (0.262) Within R2 0.534 0.348 0.14 0.187 No. of Obs 145 570 578 459 F-Statistics 31.352 15.371 6.253 7.174 Prob(F-Stat>0) 0.000 0.000 0.000 0.000 Risk-taking is proxied by the natural log of the market z-score, the standard deviation of stock market returns (stock volatility), and the natural log of NPL/CAP. The panel regressions are estimated using the country- and year- fixed effects. *, ** indicate the significance levels of 10%, and 5% respectively. # indicates the coefficient value zero that falls outside one standard deviation of the estimate. The numbers in parentheses are p-values.

33

Table 7 Risk-taking, DI coverage and corporate governance with interaction terms Sample: all countries; 1996-2003 (1)

(2)

(3)

(4)

Dependent variable

Market z-score

Market z-score

Stock Volatility

NPL/Cap

Method

Panel

Cross-Section

Panel

Panel

-0.210 (0.575) 0.027 (0.654) 4.359** (0.000) 0.057 (0.560) 0.097# (0.299) -0.114 (0.500) 0.013# (0.299) -0.019** (0.001) -0.025** (0.003) 0.171** (0.000) 0.204# (0.241) -0.126* (0.086) 1.545** (0.000) -0.048** (0.009) -0.338** (0.000) 0.543# (0.303) -1.193# (0.158) 0.003 (0.996) 0.386 (0.450) 0.807 (0.553) 0.292 1379 23.428 0.000

0.267** (0.000) -0.098** (0.000) 4.873** (0.000) -0.176# (0.224) -0.387** (0.022) -0.456* (0.077) 0.070** (0.024) 0.017 (0.356) 0.004 (0.837) 0.229** (0.004) 0.421* (0.090) -0.633** (0.000) 0.897** (0.002) -0.017 (0.470) -0.779** (0.000) 0.167** (0.000) -6.242** (0.022) -2.406** (0.001) 0.230 (0.607) 1.713** (0.000) 0.696 307 46.635 0.000

-0.013** (0.045) 0.002** (0.044) -0.008# (0.190) -0.004** (0.028) 0.001 (0.449) 0.003# (0.287) -0.000* (0.058) 0.000# (0.179) 0.001** (0.000) 0.000 (0.646) -0.003 (0.376) 0.003** (0.006) -0.026** (0.000) -0.001* (0.061) 0.008** (0.000) -0.016# (0.100) -0.011 (0.469) (0.000) (0.990) 0.011# (0.227) 0.077** (0.001) 0.123 1390 9.596 0.000

-0.525 (0.413) 0.079 (0.448) -10.321** (0.000) -0.115 (0.479) -0.216# (0.134) 0.852** (0.001) -0.045** (0.008) 0.030** (0.000) 0.009 (0.449) 0.057 (0.364) -1.581** (0.000) -0.214* (0.051) 2.920** (0.000) -0.179** (0.000) 0.135* (0.084) -2.030** (0.015) -0.349 (0.782) 0.36 (0.721) -1.475# (0.129) 8.570** (0.000) 0.224 1174 15.92 0.000

Covdepint t-1 Covdepint_sq t-1 Capital/TA 3 Largest Shareholders Foreign-Owned Govt-Owned Govt-Owned × Covdepint_sq Foreign-Owned × Covdepint_sq 3 Largest Shareholders × Covdepint_sq Capital/TA × Covdepint_sq Liquid Asset/TA Cost/Income Deposit Share Total assets Market beta GDP/Cap t-1 GDP Growth t-1 Inflation t-1 Real Int Rate t-1 Constant Within R2 No. of Obs F-Statistics Prob(F-Stat>0)

34

Table 8 Risk-taking, DI coverage and corporate governance with interaction terms Sample: industrialized countries; 1996-2003 (1)

(2)

(3)

(4)

Dependent variable

Market z-score

Market z-score

Stock Volatility

NPL/Cap

Method

Panel

Cross-Section

Panel

Panel

0.361 (0.787) -0.076 (0.728) 3.161** (0.000) -0.236# (0.107) 0.023 (0.859) 3.090** (0.007) -0.003 (0.970) -0.005 (0.572) -0.033** (0.005) 0.619** (0.000) 0.034 (0.902) 0.287* (0.069) 1.701** (0.003) -0.098** (0.000) -0.382** (0.000) 2.620# (0.287) 3.043# (0.303) -2.844 (0.474) 0.211 (0.954) -6.734 (0.457) 0.357 809 19.367 0.000

-0.249** (0.031) -0.021 (0.493) 2.776** (0.000) 0.011 (0.946) -0.604** (0.017) -0.733# (0.297) 0.215 (0.474) 0.050** (0.042) -0.058** (0.026) 0.785** (0.000) 1.129** (0.003) 0.053 (0.859) 0.527# (0.166) -0.063** (0.039) -0.706** (0.000) 1.103** (0.000) -6.478 (0.418) 27.700** (0.020) -7.703** (0.005) -0.786 (0.503) 0.762 162 53.749 0.000

-0.024# (0.237) 0.004# (0.248) 0.001 (0.932) -0.001 (0.502) 0.005** (0.007) -0.043** (0.013) 0.001 (0.612) -0.000# (0.190) 0.001** (0.000) -0.003** (0.043) 0.010** (0.023) 0.001 (0.669) -0.027** (0.001) 0.000 (0.416) 0.007** (0.000) -0.034 (0.358) -0.058# (0.191) 0.120** (0.043) 0.02 (0.715) 0.146# (0.281) 0.174 812 8.248 0.000

-4.134** (0.027) 0.708** (0.020) -9.976** (0.000) -0.305# (0.162) -0.335** (0.034) 2.639# (0.149) -0.160# (0.145) 0.013# (0.175) 0.020# (0.159) -0.832** (0.000) -1.547** (0.000) -1.097** (0.000) 3.697** (0.000) -0.181** (0.000) -0.173# (0.110) -4.618# (0.184) 2.133 (0.551) -14.283** (0.004) -0.72 (0.875) 23.432* (0.068) 0.361 715 17.497 0.000

Covdepint t-1 Covdepint_sq t-1 Capital/TA 3 Largest Shareholders Foreign-Owned Govt-Owned Govt-Owned × Covdepint_sq Foreign-Owned × Covdepint_sq 3 Largest Shareholders × Covdepint_sq Capital/TA × Covdepint_sq Liquid Asset/TA Cost/Income Deposit Share Total assets Market beta GDP/Cap t-1 GDP Growth t-1 Inflation t-1 Real Int Rate t-1 Constant Within R2 No. of Obs F-Statistics Prob(F-Stat>0)

35

Table 9 Risk-taking, DI coverage and corporate governance with interaction terms Sample: Emerging market economies; 1996-2003 (1)

(2)

(3)

(4)

Dependent variable

Market z-score

Market z-score

Stock Volatility

NPL/Cap

Method

Panel

Cross-Section

Panel

Panel

-0.050 (0.900) -0.024 (0.687) 3.810** (0.000) 0.045 (0.736) -0.008 (0.955) -0.422** (0.005) -0.005 (0.669) -0.011# (0.211) 0.018# (0.152) 0.191** (0.000) -0.103 (0.607) -0.165** (0.022) -0.136 (0.727) 0.148** (0.000) -0.131** (0.037) -0.5 (0.363) -0.450 (0.573) -0.027 (0.968) -0.13 (0.780) -0.428 (0.620) 0.381 570 14.983 0.000

0.263** (0.005) -0.076** (0.002) 7.770** (0.000) 0.077 (0.744) 0.153 (0.377) -0.387# (0.108) 0.024 (0.402) -0.039** (0.021) 0.007 (0.755) 0.107* (0.088) 0.405# (0.160) -0.487** (0.009) 0.632# (0.200) 0.096** (0.011) -0.627** (0.000) 0.126** (0.018) -7.274** (0.005) -2.596** (0.000) -0.429# (0.181) -0.403 (0.522) 0.690 145 25.373 0.000

-0.008 (0.417) 0.002# (0.256) -0.001 (0.966) -0.003# (0.318) 0.000 (0.905) 0.008** (0.033) -0.000# (0.288) 0.000# (0.275) 0.000# (0.210) -0.001# (0.288) -0.007# (0.158) 0.003* (0.092) -0.006 (0.568) -0.003** (0.000) 0.007** (0.000) -0.008 (0.577) -0.012 (0.542) -0.004 (0.832) 0.015# (0.192) 0.087** (0.000) 0.138 578 5.417 0.000

0.290 (0.731) -0.029 (0.824) -7.025** (0.000) 0.168 (0.544) 0.095 (0.750) 0.673** (0.024) -0.017 (0.430) 0.031* (0.073) -0.033# (0.194) 0.015 (0.874) -1.808** (0.000) 0.029 (0.828) 1.425* (0.081) -0.029 (0.692) 0.300** (0.017) -1.526# (0.163) -1.073 (0.500) 0.775 (0.545) -1.722# (0.134) 1.708 (0.338) 0.207 459 6.737 0.000

Covdepint t-1 Covdepint_sq t-1 Capital/TA 3 Largest Shareholders Foreign-Owned Govt-Owned Govt-Owned × Covdepint_sq Foreign-Owned × Covdepint_sq 3 Largest Shareholders × Covdepint_sq Capital/TA × Covdepint_sq Liquid Asset/TA Cost/Income Deposit Share Total assets Market beta GDP/Cap t-1 GDP Growth t-1 Inflation t-1 Real Int Rate t-1 Constant Within R2 No. of Obs F-Statistics Prob(F-Stat>0)

36