Does Increased Shareholder Liability Always Reduce Bank Risk 3 Dong Beom Choi Haelim Anderson 1 Daniel Barth 2 1 Federal Deposit Insurance Corporation 2 Office of Financial Research, U.S. Department of Treasury 3 Seoul National University 19th Annual FDIC/JFSR Bank Research Conference September 2019 * The views expressed in this presentation are those of the authors and are not necessarily reflective of views at the FDIC or OFR, Department of Treasury. 1 / 15
Motivation • Bank took excessive risks during the 2007-2009 crisis • poor incentives under limited liability and public deposit insurance • In response to the crisis, a number of countries substantially increased the coverage of their safety nets 2 / 15
Motivation • Bank took excessive risks during the 2007-2009 crisis • poor incentives under limited liability and public deposit insurance • In response to the crisis, a number of countries substantially increased the coverage of their safety nets • Financial reforms tightened regulatory and supervisory controls • These policies do not address the fundamental moral hazard problem • Other policies are aimed to improve the corporate governance of banks • One proposal-Increasing Shareholder Liability • Does increased shareholder liability always reduce bank risk-taking? 2 / 15
Motivation • Double liability: institutional architecture for reducing bank risk and increasing depositor protection until the 1930s - if a bank failed, shareholders were liable up to the par value of their shares to pay depositors and other creditors - in addition to the losses from their initial investment 3 / 15
Motivation • Double liability: institutional architecture for reducing bank risk and increasing depositor protection until the 1930s - if a bank failed, shareholders were liable up to the par value of their shares to pay depositors and other creditors - in addition to the losses from their initial investment • Our question: Did double liability reduce bank risk-taking ? • It forced shareholders to absorb losses when a bank failed • It insulated depositors from losses when a bank failed • Wealth transfer between shareholders and depositors: what does that mean for bank risk-taking behavior? 3 / 15
What We Do • A model demonstrating two competing effects of double liability on risk-taking: 1 A reduction in bank risk due to greater “skin in the game” 2 An increase in bank risk due to endogenous reduction in market discipline by depositors 4 / 15
What We Do • A model demonstrating two competing effects of double liability on risk-taking: 1 A reduction in bank risk due to greater “skin in the game” 2 An increase in bank risk due to endogenous reduction in market discipline by depositors • Novel identification strategy to test the effectiveness of double liability on: 1 Bank risk immediately prior to the Great Depression 2 Bank runs during the Great Depression 4 / 15
Findings • We find no evidence that double liability reduced bank risk prior to the Great Depression - In the context of our model, this suggests reduced market discipline is substantial 5 / 15
Findings • We find no evidence that double liability reduced bank risk prior to the Great Depression - In the context of our model, this suggests reduced market discipline is substantial • We do find evidence that double liability increased deposit stickiness during the Great Depression 5 / 15
Findings • We find no evidence that double liability reduced bank risk prior to the Great Depression - In the context of our model, this suggests reduced market discipline is substantial • We do find evidence that double liability increased deposit stickiness during the Great Depression • Takeaway: 1 double liability helped mitigate ex post bank runs, 2 which weakens market discipline, 3 and may have failed to reduced ex ante moral hazard 5 / 15
Model: The Effect of Double Liability on Shareholders and Depositors • Double liability directly reduces bank risk-taking with greater shareholder skin-in-the-game 6 / 15
Model: The Effect of Double Liability on Shareholders and Depositors • Double liability directly reduces bank risk-taking with greater shareholder skin-in-the-game • Double liability also reduces market discipline - Depositors better protected when a bank fails → “information insentive” - attracting less sophisticated depositors 6 / 15
Model: The Effect of Double Liability on Shareholders and Depositors • Double liability directly reduces bank risk-taking with greater shareholder skin-in-the-game • Double liability also reduces market discipline - Depositors better protected when a bank fails → “information insentive” - attracting less sophisticated depositors → Stickier deposits, reduced withdrawal risk for bankers (Calomiris and Kahn 1991, Diamond and Rajan 2001) 6 / 15
Model: The Effect of Double Liability on Shareholders and Depositors • Double liability directly reduces bank risk-taking with greater shareholder skin-in-the-game • Double liability also reduces market discipline - Depositors better protected when a bank fails → “information insentive” - attracting less sophisticated depositors → Stickier deposits, reduced withdrawal risk for bankers (Calomiris and Kahn 1991, Diamond and Rajan 2001) 1 Double liability reduces ex-post deposit outflows when negative information arrives 2 Effect on ex-ante risk-taking is unclear 6 / 15
Identification • Identifying the ceteris paribus effectiveness of double liability is not easy • Ideal empirical test would be to compare banks with: 1 Identical regulation (e.g., capital and reserve requirements and branching restrictions) 2 Identical supervision 3 Identical local economic conditions 4 But different liability rules 7 / 15
Identification • Identifying the ceteris paribus effectiveness of double liability is not easy • Ideal empirical test would be to compare banks with: 1 Identical regulation (e.g., capital and reserve requirements and branching restrictions) 2 Identical supervision 3 Identical local economic conditions 4 But different liability rules • Our strategy: compare national banks and state Federal Reserve member banks in New York and New Jersey (2nd district) 7 / 15
Comparing National and State Fed-member Banks in NY and NJ 1 State fed-member and national banks faced identical regulations 8 / 15
Comparing National and State Fed-member Banks in NY and NJ 1 State fed-member and national banks faced identical regulations 2 National and state banks were subject to different liability rules • All national banks subject to double liability • NY state banks: double liability vs NJ state banks: single liability • The Federal Reserve Act did not specify the liability structure of state member banks 8 / 15
Comparing National and State Fed-member Banks in NY and NJ 1 State fed-member and national banks faced identical regulations 2 National and state banks were subject to different liability rules • All national banks subject to double liability • NY state banks: double liability vs NJ state banks: single liability • The Federal Reserve Act did not specify the liability structure of state member banks 3 NY and NJ state fed-member banks supervised by NY Fed vs all national banks supervised by OCC 8 / 15
Comparing National and State Fed-member Banks in NY and NJ 1 State fed-member and national banks faced identical regulations 2 National and state banks were subject to different liability rules • All national banks subject to double liability • NY state banks: double liability vs NJ state banks: single liability • The Federal Reserve Act did not specify the liability structure of state member banks 3 NY and NJ state fed-member banks supervised by NY Fed vs all national banks supervised by OCC • Identifying Assumption : Differences between state fed-member and national banks that are not due to liability structure are the same in NY and NJ. = comparing means across four types of banks ⇒ = a diff-in-diff style analysis ⇒ 8 / 15
Data • Hand-collected, semi-annual data from 1926-1933 • Data come from Rand McNally Bankers’ Directory 9 / 15
Estimation • Effect of liability structure on bank risk-taking (1926-1929) and bank runs (1926-1929, 1930-1932) 10 / 15
Estimation • Effect of liability structure on bank risk-taking (1926-1929) and bank runs (1926-1929, 1930-1932) 1 Bank risk-taking before the Great Depression: y i,t = β 0 + β sb SB i + β nj NJ i + β t T t + β sb,nj × SB i × NJ i + X i,t + ε i,t - y i,t : cash ratio (liquidity buffer), or equity ratio (capital buffer) 10 / 15
Estimation • Effect of liability structure on bank risk-taking (1926-1929) and bank runs (1926-1929, 1930-1932) 1 Bank risk-taking before the Great Depression: y i,t = β 0 + β sb SB i + β nj NJ i + β t T t + β sb,nj × SB i × NJ i + X i,t + ε i,t - y i,t : cash ratio (liquidity buffer), or equity ratio (capital buffer) - Focus: β sb,nj , on state-bank NJ interaction 10 / 15
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