Credibility of Non-Insurance and Governance as Determinants of Market Discipline and Risk-taking in Banking

1
Credibility of Non-Insurance and Governance as
Determinants of Market Discipline and Risk-taking
in Banking

• Penny Angkinand
• University of Illinois, Springfield
•  
• Clas Wihlborg
• Copenhagen Business School
• The 2006 CFR Fall Workshop, October 25th

2
SUMMARY

• The effectiveness of market discipline on
  risk-taking depends on
• (i) the existence and credibility of
  non-insurance of depositor and creditor groups,
  and
• (ii) governance structures of banks as
  reflected in managerial incentives relative to
  shareholders and creditors.
• Empirical analysis using bank level data for a
  sample of industrialized and emerging market
  countries during 1995-2005.
• Proxies for governance variables (bank-specific
  and country level) government ownership, foreign
  ownership, concentration of ownership,
  shareholder rights, and private monitoring.

3
OUTLINE

• The impact of deposit insurance on risk taking
  and market discipline the role of Credibility of
  Non- Insurance
• The effect of governance characteristics on the
  relationship between deposit insurance and risk
  taking.
• Hypotheses
• emphasize the hypothesis with respect to the
  quality of bank governance
• Empirical Evidence
• emphasize the measures of banks risk taking,
  deposit insurance coverage, and proxies of bank
  governance

4
Starting Points

• Due to fear of bank failures and contagion,
  supervisory authorities and governments in all
  countries offer some degrees of explicit or
  implicit deposit insurance. As a result market
  discipline can be weak.
• Regulatory and supervisory structures for banks
  may not substitute effectively for market
  discipline. Excess risk-taking will take place.

5
Deposit Insurance and Bank Risk Taking

• Empirical evidence in the literature
• The existence and higher coverage of explicit
  deposit insurance schemes increase risk taking
  and banking crises.
• Implicit insurance is sometimes captured by
  proxies of institutional characteristics, legal
  system, and strictly regulated environment.
• Demirgüç-Kunt and Detragiache (1997, 2002) and
  Hutchison and McDill (1999), Barth et al (2004),
  Hovakimiam et al (2003), Demirgüç-Kunt and
  Huizinga (2004), Nier and Baumann (2006).
• Explicit deposit insurance reduces or has no
  impact on risk taking.
• Eichengreen and Arteta (2002), Hoggarth et al
  (2005), Gonzales (2005), Gropp and Vesala (2004)

6
Credibility of Non-Insurance and Risk Taking

• Angkinand and Wihlborg (AW, 2005), linking
  explicit coverage and implicit protection,
  hypothesize and estimate a U-shaped relationship
  between explicit DI coverage and banks risk
  taking.
• The absence of explicit guarantees leads to
  strong expectations that governments and
  regulators will bail out all creditors in times
  of financial distress. Thus, non-insurance of all
  creditors is not credible.
• It can be expected that the credibility of
  non-insurance increases as explicit deposit
  insurance coverage expands.
• ENABLE CREDIBLE NON-INSURANCE OF SOME CREDITOR
  GROUPS AND SHAREHOLDERS Market Discipline

7
Figure 1a. Extent of Credible Non-insurance
8
Hypotheses (from AW 2005)

• Hypothesis 1
• The relationship between risk-taking incentives
  and explicit deposit insurance coverage is likely
  to be U-shaped such that (excess) risk-taking is
  minimized at a positive but partial deposit
  insurance coverage.

9
Credibility of Non-Insurance and Risk Taking

• Effective market discipline depends on three
  factors
• the coverage of explicit deposit insurance
  schemes
• the credibility of non-insurance of those not
  covered by explicit schemes
• the relationship between the coverage of explicit
  insurance and the credibility of non-insurance,
  which depends on
• institutional and supervisory environment
• bank governance

10
Factors Affecting the Credibility of Non-Insurance

• The institutional and supervisory characteristics
• Powers of Supervisors, Powers and Procedures for
  Prompt Corrective Action, Rule of Law, and
  Corruption (analyzed in AW, 2005)
• Bank corporate governance

11
Hypotheses (from AW 2005)

• Hypothesis 2
• Strengthened institutional environment and
  supervision enhance the market discipline and
  therefore reduce risk taking. This reduction in
  risk-taking is relatively large at low levels of
  explicit coverage of deposit insurance schemes.

12
This Paper

• We extend the argument developed in AW (2005)
  that the relationship between risk taking and
  explicit DI coverage is likely to be U-shaped by
  using bank-specific data.
• Focus on how the governance of banks affects the
  disciplinary effect of partial deposit insurance
  system.

13
Corporate Governance and Bank Risk Taking

• Good governance managers maximize
  shareholders wealth.
• Governance is influenced by the ownership
  structures of banks and the explicit or implicit
  contractual relationship between shareholders and
  managers.
• Ownership of banks and risk taking
• State Ownership
• Foreign ownership
• Bank concentration ( shares of three largest
  shareholders)

14
Credibility of Non-Insurance, Corporate
Governance, and Risk Taking

• How quality of governance in banks affects the
  relationship between explicit DI coverage and
  risk taking.
• at low and high levels of the DI coverage,
  shareholders prefer excessive risks.
• at an intermediate range of the DI coverage where
  market discipline is effective, risk taking is
  reduced.
• Therefore, we expect that a higher quality of
  bank governance leads to a more pronounced
  U-shape relationship.

15
Hypothesis With Respect To Quality of Bank
Governance

• Hypothesis 3
• The relationship between explicit deposit
  insurance coverage and risk-taking is described
  by a flatter curve for banks with relatively low
  quality of governance from shareholders point of
  view.

16
Figure 1b. Impact of Bank Governance
17
Model Specification
We estimate the following model specification for
risk-taking in bank j in country i in period t
EC Explicit Deposit Insurance Coverage
The effect of CorpGov on the relationship between
explicit DI coverage and risk taking EC2i,t ?
CorpGovj,i,t
18
Data

• The data is an unbalance panel covering a total
  of 518 banks in 53 countries of which 16 are
  industrial and 37 emerging market countries for
  the period 1995-2005.

19
Proxies for Risk Taking

• NPL/Capital (Natural Logarithm)
• Adjusted NPL/Total Capital
• Standard Deviation of NPL/Average of Capital
• Bankscope database
• Proxies for the bank willingness to expose the
  bank to the possibility that loan losses exceed
  equity capital.
• Adjusted an adjustment factor

20
Additional Proxies for Risk Taking

• NPL/Total Assets
• Adjusted NPL/Total Assets
• Risk-Weighted Assets/Total Assets
• Standard Deviation of Capital/Average of Capital
• Volatility of Stock Price
• Estimation Methodology
• Random Effects Model
• OLS (when standard deviation of NPL or capital is
  used.)

21
Deposit Insurance Coverage

• The interval variable of the ratio of deposit
  insurance coverage per deposit per capita
  (covdep)
• (authors calculation based on the data from
  Demirgüç-Kunt et al., 2005.)
• Covdepint 0 if there is no explicit deposit
  insurance
• 1 if 0 lt covdep lt 1
• 2 if 1 covdep lt 2
• 3 if 2 covdep lt 3
• 4 if 3 covdep lt 5
• 5 if 5 covdep lt 10
• 6 if 10 covdep lt 15
• 7 if 15 covdep lt 20
• 8 if 20 covdep lt 50
• 9 if covdep 50
• 10 for the full coverage.

22
Deposit Insurance Coverage

• Additional variables used for the robustness
  check
• The natural logarithm of (1covdep)
• The interval variable of the ratio of deposit
  insurance coverage per GDP per capita (covgdp)

23
Proxies for Governance

• 1. Bank-Specific Governance or Ownership
  Variables (Reuters)
• Foreign-Owned
• Government-Owned
• Three Largest Shareholders (Bank Concentration)
• Institution-Owned
• 2. Country-Level Governance Variables
• Private Monitoring (Barth et al, 2004)
• Shareholder and Creditor Rights (La Porta et al,
  1998)

24
Macro and Bank-Specific Control Variables

• Bank-specific control variables
• Net Interest Margin/Total Assets
• Capital/Total Assets
• Cost/Income
• Total deposit of each bank/total deposits of all
  banks in a country
• Macroeconomic variables
• Real GDP Growth Rate
• Inflation
• Real Interest Rate

25
Empirical Result I Proxies of Risk Taking

• First, compare regressions using alternative
  proxies for risk taking (Table 3)
• Focus on ln(NPL/Cap) and StdNPL/AvgCapita

26
Empirical Result II Credibility of
Non-Insurance and Governance

• Include bank-specific and country-specific
  corporate governance variables (table 4).
• Add the interaction terms between corporate
  governance variables and insurance coverage
  (Covdepint) (table 5).

27
Table 5
Bank- and country-specific control variables are
included, but not reported
28
Empirical Result II Credibility of
Non-Insurance and Governance

• Evidence of the U-shaped relationship between
  risk taking and deposit insurance coverage
• The coefficient of Covdep is negative, and the
  coefficient of (Covdep)2 is positive, reflecting
  a U-shaped relationship.
• reflecting that the non-insurance of banks
  creditors is not credible
• less robust when using the bank specific data
• less significance for emerging market economies.
  Possibly explained by the significance of other
  variables capturing Too Big To Fail.

29
Empirical Result II Credibility of
Non-Insurance and Governance

• The County-Level Governance Variables (from Table
  4)
• Shareholder rights, creditor rights, and private
  monitoring have negative effects on risk taking.
• Shareholder rights are significant consistently.

30
Empirical Result II Credibility of
Non-Insurance and Governance

• Bank-Specific Governance Variables
• The coefficients of individual variable and its
  interaction with deposit insurance coverage are
  significant, indicating that external and
  internal factors influence market discipline
  interactively as predicted (Table 5).
• Hypothesis 3 risk taking is expected to be
  higher at very low and very high levels of DI
  coverage (where the coverage is not at optimal)
  in banks with relatively high quality of
  governance.

31
Empirical Result II Credibility of
Non-Insurance and Governance

• Supporting the Hypothesis 3?
• Compare the signs for the squared covdepint and
  its interaction term with governance variable.
  For Low quality of governance, the neg. sign of
  interaction term a flatter U-shaped, supporting
  the hypothesis.
• Draw figures describing the relationship between
  risk taking and DI coverage for different levels
  of ownership.

32
The Effect of Foreign Ownership

• Individual effect Foreign ownership reduces risk
  taking.
• Interactive effect a more pronounced U-shaped
  relationship at a high level of foreign
  ownership, supporting the Hypothesis 3 if foreign
  ownership represents higher quality of
  governance.
• The impact of foreign ownership is strong in
  countries with relatively low explicit DI
  coverage/lack of credibility of non-insurance.

33
Foreign Ownership Affecting the Relationship
between Risk Taking and DI Coverage
34
The Effect of Ownership Concentration

• Individual Effect ambiguous
• Interactive effect a more pronounced U-shaped
  relationship at a high level of foreign
  ownership, supporting the Hypothesis 3, for a
  sample of industrial countries.

35
Bank Concentration Affecting the Relationship
between Risk Taking and DI Coverage
36
The Effect of State Ownership

• Individual effect State ownership increases risk
  taking.
• Interactive effect The effect of state ownership
  in increasing risk taking is smaller where
  deposit insurance coverage is high (indicated by
  a negative sign of the interaction term).
• The Hypothesis 3 is confirmed if government
  ownership is associated with low quality of
  governance.

37
Sensitivity Analysis
Two Stage Least Square, assuming Capital/TA or
Cost/Income is endogeneous.
38
CONCLUSION

• There is the U-shaped relationship between risk
  taking and deposit insurance, reflecting that
  extensive non-insurance of banks creditors is
  not credible. This relationship is more robust
  for industrial countries.
• For the impact of ownership variables, government
  ownership increases risk-taking, foreign
  ownership reduces risk-taking, ownership
  concentration is ambiguous and has opposite
  effects in industrial and emerging market
  countries.
• The impact of bank governance on risk taking
  seems to be strong in countries with low DI
  coverage or high implicit coverage caused by lack
  of credibility of non insurance.