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An evaluation of the deposit insurance subsidisation of Australian banks
PACIFIC-BASIN FINANCE JOURNAL ELSEVIER
Pacific-BasinFinanceJournal 4 (1996) 421-435
An evaluation of the deposit insurance subsidisation of Australian banks Steven A. Dennis *, Ah Boon Sire Department of Finance, California State UniversiO', Fullerton, CA 92634, USA
Abstract To the extent that deposits in Australian banks are guaranteed, Australian banks receive deposit insurance at no cost. This cost is ultimately borne by the taxpayers of Australia. This papel examines the amount of subsidisation using techniques similar to studies of other deposit insurance systems. We show that the estimate for the deposit insurance premium depends critically upon the method of estimating the market value of assets and the asset volatility of the bank. We find that Australian banks received substantial insurance subsidies in 1990, 1991, and 1992. JEL classification." G21; G28 Keywgrd~" Deposit insurance;Australia;Banking
1. Introduction Prudential supervision makes banks the most closely monitored of financial intermediaries operating in Australia. This is also true of other industrialised countries, such as the United States and the United Kingdom. The Banking Act of 1959, the Reserve Bank Act of 1959, the Financial Corporations Act of 1974, and the Bank Integrations Act of 1991 empower the Reserve Bank of Australia (RBA) to maintain stabiiity in the financial system as a whole. As one of its primary responsibilities, The Banking Act imposes a duty on the
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422
S.A. Dennis, A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
Reserve Bank of Australia to protect depositors of banks, l However, a former Governor of the R B A has stated,
"... (the) Banking Act is silent in regard to the priority to be given to depositors. So the legislation is less than a guarantee to depositors of full repayment and is no assurance of the solvency of an individual bank, nor of how the parties would emerge in the event of a winding-up." (Johnson, 1985, p. 572)
The ambiguity arises because of the nature of repayment, and whether this means repayment in full. However, Hogan and Sharpe (1990) assert that there is a public perception that the R B A would not allow depositors to lose in the event of a bank failure. Hogan and Sharpe (1990) suggest this perception is reinforced by: (i) official statements pointing to the undoubted strength and safety of the banking system; and (ii) likely political intervention should small banks appear in jeopardy. Furthermore, Hogan and Sharpe (1990) state,
" T h i s situation may be depicted as the ' w o r s t of both worlds' in that ... (it) extends protection to a large group of depositors ... while, on the other hand, the uncertain degree of protection may not prevent a contagion effect ... there is every prospect of political pressure being exerted with the view to protecting small depositors (and large ones as well), thereby transferring the incidence of the bank's losses onto general taxpayers." (p. 132)
Thus, it would appear that deposits in Australian banks are insured, at least to some degree. Kane and Kaufman (1992) have described the credit enhancement arising from such a system as " i m p l i c i t deposit insurance". 2 However, Australian banks pay no explicit deposit insurance premium as is the case with the banking system in the United States, where banks pay for explicit deposit insurance contracts. The insurance subsidy for Australian banks is granted by the R B A and is paid for, ultimately, by the taxpayers of Australia. The implicit guarantee of deposits in Australian banking is currently under review by the RBA.
t Actually, the Reserve Bank of Australia has only the responsibility for privately-owned banks, though many of the state-owned banks have recently come under the protection of the RBA. Deposits in the Commonwealth Bank of Australia are explicitly protected by the full faith and credit of the Commonwealth Government of Australia. However, this does not alter our investigation in any significant manner as the burden of any subsidisation still lies with the taxpayers of Australia. Therefore, for the remainder of this paper, we use the terms RBA and government interchangeably. z The likelihood of depositor repayment increases substantially for the four "major" banks in Australia, which account for approximately two-thirds of all bank assets in Australia.
S.A. Dennis, A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
423
Therefore, it is important that regulators, banks, and market participants alike understand the value of the deposit guarantee, or alternatively, the government's obligation. To the extent that regulation constrains the activities of banks, a cost of this implicit deposit insurance is already imposed on Australian banks. 3 However, a fallacy lies in arguing that the RBA should not charge a deposit insurance premium because the cost of regulation equals the deposit insurance value. This ignores other benefits of being regulated, such as funding cost advantages and access to a lender of last resort. Moreover, it is unclear whether the employment of regulation by itself is efficient. Perhaps the employment of regulation and some explicit deposit insurance premium is optimal. This paper attempts to determine the degree to which Australian banks are subsidised by the Reserve Bank of Australia for deposit insurance. Using methodology similar to that used for studies of other deposit insurance systems, we determine that there is a substantial subsidy granted to Australian banks. Over the three-year period 1990-1992, our estimates for the value of deposit insurance to Australian banks (alternatively, the government's actuarially fair claim) range from $30.7 million to $3.6 billion. Our estimates employ two methodologies and two potential closure policies of the government. While our estimation period covers a turbulent period in Australian banking, the estimates suggest that the Australian government has a large potential claim in the event of bank failure. The remainder of this paper is organised as follows: Section 2 describes the model employed and Section 3 describes our data. Section 4 provides the empirical results and Section 5 concludes.
2. A model of deposit insurance pricing Merton (1977) was the first to demonstrate that the insurance benefit to financial institutions can be calculated using an option pricing approach. Marcus and Shaked (1984), Ronn and Verma (1986), Pennacchi (1987), Kendall (1992) and others have derived methodologies for empirically examining the value of this deposit insurance. The model is as follows: Consider a bank with B 1 total deposits and B~ other liabilities such that the bank has total debt B = B l + B2. When the terminal value of the bank's assets, V r, is higher than the value of total liabilities, the holders of deposits receive the future value of their deposits. However, if the terminal value of assets does not exceed the value of liabilities, the holders of
3 This point is often argued by Australian banks.
S.A. Dennis, A.B. Sire/Paci[ic-Basin Finance Journal 4 (1996)421-435
424
deposits would receive receive
(Bj/B)V T. 4
Thus, at the end of the period, depositors
where r h is the interest rate paid on deposits. Assuming Vr is exogenous, the insurance premium would be the price of a European put option on the deposits with a strike price equal t o B 1 (if only the principal is insured) or Bj e"" (if the entire future value of deposits is insured). 5 The underlying "asset" price in this case is BI
K' = ~ V , ( l - 6 ) , where ~ is the dividend per dollar of value of total assets paid by the bank during the period. Then, the value of deposit insurance is determined as:
pe"'= B,e""U( y + G,~[t) - V'N( y), where,
ln((Bne'")/V')-(o,f-t)/2 Y= o-~ or
p = B l e ( " ' - " " N ( y + ~,~-t) - V ' e
"iN(y).
When r 1 = r, we have,
p=BiU(y+<,~/-t)-V'e
"'U(y).
(1)
The put equation given in (1) is valid only for the case when the deposit insurance premium is paid by the depositors. In the case when the premium is paid by the bank, the equation should be modified to reflect the reduction in asset value caused by the payment of the premium. In the context of this paper, we recognise that Australian banks do not currently pay the insurance premium. Therefore, we make no adjustments in the estimations. ~ We can use Eq. (1) to determine the value of any deposit insurance subsidisation received by Australian banks. In empirical applications of the above model, both the " t r u e " value of the bank's assets and the variance of returns on those assets are unknown. However, Ronn and Verma (1986) recognise that the equity
a This assumes all debt of the bank to be of equal seniority. 5 We assume that tbe entire future value of deposits is ,guaranteed. ~' Hov~e',er, if the RBA were to begin to charge for explicit deposit insurance, this premium should be reflected in the pricing of deposit insurance. For a discussion, see Kendall (1992).
S.A. Dennis. A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
425
value of the bank can be viewed as a call option on the assets of the bank, written by the debtholders of the bank. Therefore, this gives an equation relating the equity value of the firm to both the true value of the assets and the volatility of returns on those assets. Incorporating the closure rule condition, Ronn and Verma (1986) model the equity value of the bank as: 7
E = VoN ( x ) - p B N ( x - ~,f-T),
(2)
where now l n [ V r / ( pBe"r)] + (o-~2T)/2 x=
Also, Ronn and Verma (1986) use the Merton (1974) equation relating the equity volatility of the bank to the asset volatility of the bank:
o-=
.o;.
(3)
If the bank's shares are publicly traded, both the value of bank equity and the volatility of equity can be obtained. This gives two nonlinear equations (Eq. (2) and Eq. (3)) in two unknowns, which can be solved for the solution pair (V,%). Once the solution pair is obtained, it can be substituted into Eq. (1) to arrive at the deposit insurance premium. Duan (1994), however, points out a shortcoming in the Ronn and Verma (1986) approach. Duan (1994) suggests that if bank assets are assumed to follow a process with constant variance (as Merton's assumes) and bank equity is a call option on bank assets, bank equity must have a nonconstant variance (Merton, 1977). This presents two problems. First, one cannot sample bank equity returns for estimates of bank equity volatility, because equity volatility is stochastic. Second, the Merton (1974) equation relating equity volatility to asset volatility assumes equity volatility is constant and therefore cannot be employed. Duan (1994) offers an alternative methodology which overcomes the shortcoming of the Ronn and Verma (1986) approach. Duan (1994) suggests that the unobserved series of market value of assets and the volatility of assets of the bank can be estimated using a time series of equity values of the bank. Eq. (2) relating the value of assets and asset volatility to equity values can be transformed such
7 The closure rule condition parameter in Eq. (2), p, identifies the point at w h i c h the regulatory authority will close the bank as a percentage of the debt value of the bank. A closure at zero net worth implies # = 1.00. A forbearance policy of 2.5r/i of the b a n k ' s debt level by the regulatory authority implies p = 0.975. More discussion of the closure rule condition in given in Section 3. For a detailed discussion, see Ronn and V e r m a (1986).
426
S.A. Dennis. A.B. Sire / Pacific-Basin Finance Journal 4 (1996) 421-435
that the value of assets is written in terms of the equity value of the bank and the volatility of assets. Then, the transformed log-likelihood function of the time series of equity values can be written as: n-
LE = -
1
2
n-
1
ln(27r) - - - l n r r ,~ . ~, 2
- ~ln(N(ct,)).
-
2o'-
In
---•, , ( ~ , )
-
#
(4)
t=2
This process gives estimates of the value of bank assets, the mean return on assets, and the volatility of returns on assets. The two parameters of interest can then be applied to deposit insurance pricing via Eq. (1).
3.
Data
The study was performed for a sample of eight publicly-traded Australian banks over the period July 1, 1989 to December 31, 1992. ~ The daily stock price series, dividend series, annual report dates, and number of shares outstanding were extracted from the ASX database for the period. Monthly statistics on total deposits, total assets, and total other liabilities, were taken from the Reserve Bank of Australia's Bulletin. In computing the market value of equity, the number of shares outstanding were multiplied by the average daily share price over the week preceding the date on the annual statements of the bank. 9 Because of the thin trading in some Australian stocks, daily stock prices were converted to weekly returns for computing equity volatility. Conversion to a weekly series would perhaps reduce any bias caused by infrequent trading. Equity volatility, required for the Ronn and Verma (1986) methodology was measured over a 52-week period preceding the annual report date for each bank. 10 The same 52-week period was used for the methodology of Duan (1994). i1
s The sample includes: Advance Bank Australia, ANZ Banking Group, Bank of Melbourne, Bank of Queensland, Challenge Bank, Metway Bank. National Australia Bank, Westpac Banking Corporation and their subsidiaries, if" any. We also used the share price at the report date and the average daily share price for the month preceding the report date. The results were similar. m The annual report dates are generally at the end of the month with ABA in May, BML and MWB in June. BQD in August, and the remaining four banks in September. ii While weekly stock prices were used for estimating the market value of assets and the volatility of returns on assets by maximising the log-likelihood equation in (4), total deposits and debt values could only be updated monthly while the number of shares outstanding could only be updated annually.
S.A. Dennis, A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
427
The analysis focuses on two values for the policy parameter, p. We employ a value of 1.00 to represent the scenario in which the RBA closes the bank at examination when the bank's net worth is zero. Studies of the deposit insurance system in the United States suggest that the model should be altered for forbearance on the part of regulators. Ronn and Verma (1986) suggest a forbearance policy of 3% of the bank's liabilities in their sample which is consistent with the FDIC's pricing policy. Gizycki and Levonian (1993) suggest that any closure rule less than 2% of the bank's liabilities in the Australian context is inconsistent with the data of their study. Therefore, we employ 2.5% (p = 0.975) as a second closure rule. There is also the issue of time to maturity of the options. Firstly, there is the question of whether it is valid to assume that the time to maturity for the put option in Eq. (1) is equal to the time to maturity of the call option in Eq. (3). Eq. (1) should have the time to the next examination as the time to maturity, whereas Eq. (3) should have the maturity of the liabilities of the bank as the time to maturity. However, Ronn and Verma (1986) note that it is reasonable to assume, because of the closure powers of the RBA, that the maturity of both options is the next examination of the bank. Second, we must be concerned with the exact timing of the next examination of the bank. If the time to the next examination is chosen incorrectly, the value of deposit insurance will be mispriced. Ronn and Verma's Table 2 demonstrates the behaviour of deposit insurance when the time to maturity is varied between 1 / 4 years and 5 years. The premium is an increasing function of the chosen time to maturity. Ronn and Verma note the problems associated with determining the exact time to the next examination in the United States. US banks submit information on a quarterly basis, but this information is largely unaudited. Determining the time of the next examination is perhaps more difficult in Australia, given that prudential regulation occurs as an ongoing, consultative process. Banks are required to produce statistical information at various frequencies, from daily to annually. However, much of the more frequently disclosed information is unaudited, though the accounting systems used to produce the data are audited. 12 Therefore, as with studies of the American deposit insurance system, the timing of the next examination is relatively difficult to ascertain. We assume that the time to the next 13 examination is one year.
L2From discussions with RBA staff. ~3Our reasoning is similar to Ronn and Verma (1986). Using time periods other than one year creates difficulties in annualising the premium. Most studies of deposit insurance assume one year as the time to examination, perhaps because it is more straightforward to discuss an annual premium.
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S.A. Dennis, A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
4. Empirical findings Tables 1 and 2 present the results for the deposit insurance premium employing the two closure rules. Table 1 reports the values of deposit insurance assuming a closure rule of 1.00 and Table 2 reports values assuming a closure rule of 0.975. In both tables, the deposit insurance premium is given in both dollars (millions) and basis points (1% = 0.01). The standard deviation of the returns on assets is given and, for estimates using Duan's methodology, the standard error for the estimate of the volatility of assets, S.E.(O'A), is also given (Duan, 1994). The market value of assets, the book value of assets, and the level of deposits are reported in millions of dollars. At the bottom of each section in the tables, the average values for the deposit insurance premium in basis points and the standard deviation of returns on assets are given. Also, the total values for the deposit insurance premium in dollars, the market value of assets, the book value of assets, and the level of deposits are given. Table 1 reports the value of deposit insurance employing a closure rule of 1.00. The left-hand column denotes the bank symbol and the year of the study. The next column provides the Ronn and Verma (1986) estimates of deposit insurance. Challenge Bank, Westpac, and ANZ received the largest insurance subsidies in 1990, while the other five banks in the sample received negligible subsidies. Again in 1991 and 1992, ANZ and Westpac received substantial insurance subsidies from the RBA. This time period corresponds to the loan quality problems both these banks were experiencing. NAB, Metway, Advance Bank, and Bank of Melbourne received little insurance subsidies over the three-year period. The total amount of insurance subsidy for the eight banks in our sample was approximately $22 million in 1990. In 1991, that figure escalated to $40.2 million, mostly due to the subsidies provided Westpac and ANZ. In 1992, the insurance subsidy for these eight banks decreased to $17.7 million. The estimates of the volatility of returns on assets are roughly 4% to 5% per annum. The estimate increases from 1990 to 1991, but then decreases in 1992 to a level just below the 1990 figure of 4.38%. The estimate for the market value of assets of the sample banks is well below the book value. The period under examination coincides with a general depression in the Australian economy, with severe depression in many residential property prices. Some of the banks in the sample are known to have had substantial exposures to the property market collapse. The next section of Table 1 provides the estimates for deposit insurance employing Duan's methodology (Duan, 1994). These estimates are much higher than the estimates using Ronn and Verma's (1986) methodology. The higher estimates for the value of deposit insurance using Duan's (1994) methodology, as compared to Ronn and Verma (1986), is also noted by Duan and Yu (1995) for the case of the deposit insuring agency in Taiwan. The wide divergence in deposit insurance premia in our study can be attributed to the estimate of asset volatility of
S.A. Dennis, A.B. Sire~ Paci[ie-Basin Finance Journal 4 (1996) 421-435
429
the bank. The estimates for the market values of bank assets are very similar using the two methodologies. However, Duan's (1994) estimates of the volatility of assets are approximately twice the Ronn and Verma (1986) estimates, on average. Duan and Yu (1995) report that both the market value of assets and the volatility of returns on assets are significantly lower for banks in Taiwan when employing Ronn and Verma' s (1986) methodology. The relative merits of the two approaches should perhaps be mentioned here. While Ronn and Verma (1986) require the volatility of equity to be nonstochastic, an assumption which is inconsistent with the model, Duan's (1994) methodology is susceptible to measurement errors. In the current context, the obvious sources of measurement errors are the monthly updates of total deposits and debt values and the annual update of the number of shares outstanding. Introduction of an error term in Eq. (2) would require a modification of the transformed log-likelihood function in Eq. (4). Ignoring this modification would lead to measurement errors in the market value of assets and, subsequently, a biased estimate of the volatility of returns on assets. As is well known, the value of an option is quite sensitive to the volatility of the underlying. With volatility estimates roughly twice the Ronn and Verma (1986) estimates, it is not surprising that the Duan (1994) methodology produces much larger values for deposit insurance. If the Duan (1994) methodology is the "most correct", the Australian taxpayers should be concerned. The estimated total deposit insurance subsidisation in 1990 is $203.1 million. In 1991, the estimate rises to $301.9 million, while in 1992, the estimate for deposit insurance for the eight banks in our sample is roughly $1.7 billion. The very large subsidy in 1992 is mostly attributable to ANZ. who is known to have experienced severe loan quality problems during this period. To estimate the insurance subsidy |br the entire Australian banking system, we determine the total market share of deposits for these eight banks as a percentage of total Australian bank deposits. These figures were 54.37%, 56.15%, and 57.29% for 1990, 1991, and 1992, respectively. Assuming the risk of the eight banks in our sample to proxy the risk for the Australian banking system, we can determine the total amount of subsidy for the banking system through the relative market share of our sample. Multiplying the subsidy for the eight banks in our sample in 1990 by the inverse of 54.37%, we find that Australian banks were subsidised for $40.7 million ($373.6 million) in 1990 using Ronn and Verma's (Duan's) methodology. Similarly, we find that the Australian banking system received a subsidy of $71.4 million ($537.7 million) in 1991 and $30.7 million ($2.9 billion) in 1992. Table 2 depicts the same analysis; however, the policy parameter is assumed to equal 0.975, which is perhaps closest to the Australian closure rule as determined by Gizycki and Levonian (1993). The decrease in the policy parameter from 1.00 to 0.975 (a forbearance policy introduction of 2.5% of the liabilities of the bank) has the effect of increasing the estimates of deposit insurance. The estimate of the
0.0182 0.0370
0.244E-04 0.759E-04
0.153 2.261
ABA ANZ
1992
0.0516
0.237E-03
0.0438
0.708E 03
0.0214 0.0805 0.0221 0.0677 0.0171 0.0191 0.1030 0.0820
0.0193 0.0697 0.0155 0.0564 0.0501 0.0244 0.0454 0.0699
0.209E-04 0.105E-03 0.743E-07 0.116E-06 0.525E-02 0.258E-04 0.120E-08 0.264E-03
0.835E-04 0.823E-03 0.557E-04 0.817E-05 0.582E-04 0.263E-06 0.175E-04 0.850E-03
0.471 17.189 0.208 0.004 0.171 0.001 0.367 21.873 40.283
0.103 1.972 0.000 0.000 14.523 0.046 0.000 5.385 22.028
ABA ANZ BML BQD CLG MWB NAB WBC Total Average
1991
/ 990 ABA ANZ BML BQD CLG MWB NAB WBC Total Average
6852 34527
6287 26725 4045 662 3142 2263 30582 31965 105672
5377 23390 3419 396 3025 1997 26724 26093 90420
MV assets
35.683 1513.6
122.20 18.910 51.975 3.659 2.204 19.701 0.000 83.273 301.922
40.580 11.293 49.852 1.7645 11.317 66.352 1.049 20.915 203.123
0.569E-02 0.508E-01
0.719E-02
0.217E-01 0.905E-03 0.139E-01 0.730E-02 0.749E-03 0.969E-02 0.227E-08 0.324E-02
0.912E-02
0.826E-02 0.599E-03 0.158E-01 0.613E 02 0.409E-02 0.370E-01 0.519E-04 0.102E-02
Premium bp
Duan (1994) methodology
era
Premium S
Premium bp
Ronn and Verma (1986) methodology
Premium s
Table 1 Risk-adjusted deposit insurance premium, p = 1.0 ~
0.05418 0.21775
0.09151
0.10301 0.07219 0.08513 0.16545 0.03469 0.08643 0.07083 0.11433
0.09864
/).06680 0.08565 0.09811 0.16738 0.04791 0.15878 0.07958 0.08491
0.00401 0.01305
0.00480 0.00519 0.00516 0.00996 0.00256 0.00369 0.00599 0.01063
0.00268 0./)0437 0.00630 0.00798 0.00300 0.00978 0.00713 0.00500
S.E.((~)
6854 34489
6287 26141 4047 662 3196 2264 31446 32522 106565
5382 23333 3419 396 3035 1996 26601 26068 90230
MV assets
7185 58755
6441 49299 4295 677 3305 2393 44512 54387 165309
5559 43457 3696 414 3277 2037 42635 46218 147293
BV assets
6271 29805
5640 20893 3729 501 2942 2034 20946 25740 82425
4914 18840 3149 288 2766 1793 20231 20421 72402
Deposits
7" 4~
4:*
2
2
C,Z
e~
1.831 0.000 1.638 0.000 0.000 11.771 17.655
0.0449 0.0768 0.0297 0.0188 0.0450 0.0513 0.0402
0.414E-03 0.804E-06 0.531E-03 0.184E-06 0.115E- 13 0.418E-03
0.183E-03
4955 838 3373 2861 33785 32147 119337
23.383 2.0t)7 8.646 16.235 0.000 83.169 1682.723 0.966E-02
0.529E-02 0.340E-02 0.281E-02 0.636E-02 0. l 16E-07 0.296E-02 0.09948
0.10340 0.14244 0.04430 0.09330 0.06545 0.07502
0.00577 0.00763 0.00289 0.00821 0.00609 0.00513
5171 782 3373 2952 33800 32145 119566
5083 836 3406 2995 51692 54673 184625
4424 591 3082 2553 23771 28146 98643
a Premium is given in both dollars (millions) and basis points (1% = 0.01 ). The market value of assets, book value of assets, and deposits are given in millions. S.E.(O" a ) is the standard error of the estimate of volatility of assets using Duan's (1994) methodology.
BML BQD CLG MWB NAB WBC Total Average
7" 4~
4~
~z
7"
0.102E-02 0.574E-03
1992 ABA ANZ 0.0199 0.0389
0.0540
0.116E 02
6.428 17.118
0.0242 0.0844 0.0241 0.0690 0.0206 0.0196 0.1050 0.0859
0.0472
0.275E 02
0.172E-02 0.203E-02 0.117E-02 0.307E-04 0.219E 02 0.327E-04 0.414E-04 0.205E-02
9.681 42.319 4.37 0.015 6.445 0.1167 0.868 52.832 116.597
0.0208 (/.(/716 0.0159 0.0575 0.0677 0.0255 0.0463 (}.(t724
0.780E-03 0.322E-03 0.330E-04 0.801E-06 0.196E-01 0.504E-03 0.2(X)E-07 0.768E-03
1991 ABA ANZ BMI, BQD CLG MWB NAB WBC Total Average
3.832 6.072 0.104 0.000 54.274 0.904 0.000 15.679 80.865
1990 ABA ANZ BML BQD CLG MWB NAB WBC Total Average
6697 33754
6147 2616 t 3954 649 3074 2211 30037 31292 103523
5254 22906 3339 388 2943 1952 26196 25544 88521
MV assets
74.778 1749.800
180.330 38.760 8(1.104 4.566 9.631 30.931 0.000 125.32 469.642
72.399 20.378 72.817 2.231 26.779 83.240 2.465 39.554 319.863
0,119E-01 0.587E-01
0. I 10E-01
0.319E-01 0.186E-02 0.215E-01 0.91 l E-02 0.327E-02 0. t52E-01 0.106E 07 0.487E-02
0.131E-01
0.147E-01 0. t 08E-02 0.231E-01 0.775E-02 0.968E-02 0.464E-0 I 0.122E-03 0.194E 02
Premium hp
Premium ~
o-~
Premium s
Premium bp
Duan (1994) methodology
Ronn and Verma (1986) methodology
Table 2 Risk-adjusted deposit insurance premium, p = 0.975 a
0.05444 0.21791
0.09212
0.10800 0.07225 0.08551 0.16418 0.03499 0.08634 0.07139 0. t 1430
0.09845
0.06686 0.08484 0.09869 0.16671 0.04800 0.16146 0.0798 t 0.08519
0.00405 0.01312
0.00505 0.00526 0.00524 0.00978 0.00258 0.00369 0.00606 0.01067
0.00269 0.00424 0.00643 0.00798 0.00303 0.01029 0.00712 0.00505
S. E.( ~ )
6691 33708
6141 25592 3951 649 312(/ 2212 30894 31835 104394
5255 22847 3339 388 2963 1950 26073 25514 88329
MV assets
7185 58755
6441 49299 4295 677 3305 2393 44512 54387 165309
5559 43457 3696 414 3277 2037 42635 46218 147293
BV assets
6271 29805
5640 20893 3729 5()1 2942 2034 20946 25740 82425
4914 18840 3149 288 2766 1793 2/1231 20421 72402
Deposits
']"
~,
4a
~.
5"
a:' 6a
.~ ~"
~"
e~
t'J
8.763 0.002 13.536 0.068 0.000 47.629 93.544
0.0487 0.0782 0.0357 0.0193 0.0459 0.0549 0.0427
0.198E-02 0.302E 05 0.439E-02 0.268E-04 0.468E- 12 0.169E-02
0.121E-02
4845 822 3298 2795 33169 31438 116817
36.354 2.657 23.078 24.369 0.001 155.76 2066.797 0.133E 01
0.822E-02 0.450E 02 0.749E-02 0.965E-02 0.550E-07 0.553E-02 0.09934
0.10336 0.14214 0.04442 0.09144 0.06586 0.07518
0.00579 0.00766 11.00293 0.00776 0.00618 0.00515
5053 769 3294 2884 33184 31421 1171)04
5083 836 3406 2995 51692 54673 184625
4424 59 I 3082 2553 23771 28146 98643
Premium is given in both dollars (millions) and basis points ( I ~7, = 0.01 ). The market value of assets, book value of assets, and deposits are given in millions. S . E . ( ~ ) is the standard error of the estimate of volatility of assets using Duan's (1994) methodology.
BML BQD CLG MWB NAB WBC Total Average
t~
4~
434
S.A. Dennis, A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
market value of assets is generally higher than the case of no forbearance. However, the estimate of the volatility of assets is also higher, thus producing a higher estimate for deposit insurance. The total deposit insurance subsidies for the Australian banking system in 1990, 1991, and 1992 are $148.2 million ($588.3 million), $209.1 million ($836.4 million), and $164.1 million ($3.61 billion), respectively, employing Ronn and Verma's (Duan's) methodology.
5. Discussion
There is ambiguity with respect to the insurance coverage Australian depositors receive. Although there is no explicit regulation stating that deposits in Australian banks are guaranteed in the event of bank failure, there is some non-zero probability that all depositors will be covered. Statements by public officials concerning the safety of the Australian banking system have kindled a public perception that such insurance exists. Recent actions by the RBA in bank failure cases would also tend to strengthen the argument that deposit insurance exists. In the debacle concerning State Bank of Victoria, all liability holders were protected as the RBA positioned the (then fully-government-owned) Commonwealth Bank to acquire the State Bank of Victoria. 14 In essence, this is complete deposit insurance. To the extent that deposit insurance exists in Australia, Australian banks are subsidised for such insurance because of the lack of premiums charged by the RBA. This paper determines the value of this implicit deposit guarantee in three turbulent years in Australian banking. We have assumed full insurance for depositors in Australian banks. To the extent that deposits have less than a full guarantee, we have estimated upper bounds for the cost of deposit insurance to the taxpayers of Australia. However, our results show that the value of the deposit guarantee may be substantial. The depositor protection provisions of the Banking Act are currently under review by RBA supervisors with some market participants arguing that the policy of "constructive ambiguity" for deposit insurance needs substantial review to determine who bears the risk of bank default (see Rogers, 1994, p. 28). One view canvassed by Rogers is that deposit insurance represents an unwarranted regulation for banks and that elimination of explicit government guarantees would "open up competition in the deposit market". However, Diamond and Dybvig (1983) suggest that the removal of all depositor protection provisions could lead to widespread financial panics.
14This case is very interesting in that the Labor Party of the state of Victoria contacted the Federal Labor Party for assistance in the debacle. Eventually, the Federal Labor Party coerced the Commonwealth Bank to acquire the State Bank of Victoria. The Victorian Governmentultimately assumed the losses of the State Bank of Victoria.
S.A. Dennis, A.B. Sim / Pac~c-Basin Finance Journal 4 (1996) 421-435
435
W e advocate a specific policy stance by the R B A regarding deposit insurance in Australia. Such a rule w o u l d eliminate any ambiguity depositors might have. To the extent that depositors charge a risk p r e m i u m c o m m e n s u r a t e with the uncertainty surrounding deposit insurance, the cost to banks o f acquiring funds m a y perhaps be reduced. Thus, the cost to individual banks of i m p o s i n g an explicit deposit insurance system is perhaps less than the full cost o f the insurance premium.
Acknowledgements This paper has benefitted f r o m helpful c o m m e n t s on earlier drafts by D a v i d Thurston, participants at the U n i v e r s i t y of M e l b o u r n e A c c o u n t i n g and Finance seminar series and at the Seventh Annual Australian Finance and Banking Conference, the editor, and a n o n y m o u s referees.
References Diamond, D. and P. Dybvig, 1983, Bank runs, deposit insurance, and liquidity, Journal of Political Economy, June, 401-419. Duan, J., 1994, Maximum likelihood estimation using price data of the derivative contract, Mathematical Finance, April, 155-167. Duan, J. and Yu, 1995, Assessing the cost of Taiwan's deposit insurance, Pacific-Basin Finance Journal 2, 73-90. Gizycki, M. and M. Levonian, 1993, A decade of Australian banking risk: Evidence from share prices, Reserve Bank of Australia - Research Discussion Paper, March. Hogan, W. and I. Sharpe, 1990, Prudential supervision of Australian banks, The Economic Record, June, 127-145. Johnson, R., 1985, Prudential supervision of banks, Reserve Bank of Australia Bulletin, March, 571-575. Kane, E. and G. Kaufman, 1992, Incentive conflict in deposit-institution regulation: Evidence from Australia, Federal Reserve Bank of Chicago Working Paper WP92-5. Kendall, S., 1992, A note on the existence and characteristics of fair deposit insurance premia, Journal of Banking and Finance, April, 289-297. Marcus, A. and I. Shaked, 1984, The valuation of FDIC deposit insurance using option pricing estimates, Journal of Money, Credit and Banking, November, 446-460. Merton, R., 1974, On the pricing of corporate debt: The risk structure of interest rates, in: R. Merton, Continuous-time Finance, Blackwell (Cambridge, MA), 1990, pp. 388-412. Merton, R., 1977, An analytic derivation of the cost of deposit insurance and loan guarantees, Journal of Banking and Finance, June, 3-11. Pennacchi, G., 1987, A reexamination of the over- (or under-) pricing of deposit insurance, Journal of Money, Credit and Banking, August, 340-360. Rogers, I., 1994, Deposit guarantees face chop, Australian Financial Review, October 12, 28. Ronn, E. and A. Verma, 1986, Pricing risk-adjusted deposit insurance: An option-based model, Journal of Finance, September, 871-895.
Pacific-BasinFinanceJournal 4 (1996) 421-435
An evaluation of the deposit insurance subsidisation of Australian banks Steven A. Dennis *, Ah Boon Sire Department of Finance, California State UniversiO', Fullerton, CA 92634, USA
Abstract To the extent that deposits in Australian banks are guaranteed, Australian banks receive deposit insurance at no cost. This cost is ultimately borne by the taxpayers of Australia. This papel examines the amount of subsidisation using techniques similar to studies of other deposit insurance systems. We show that the estimate for the deposit insurance premium depends critically upon the method of estimating the market value of assets and the asset volatility of the bank. We find that Australian banks received substantial insurance subsidies in 1990, 1991, and 1992. JEL classification." G21; G28 Keywgrd~" Deposit insurance;Australia;Banking
1. Introduction Prudential supervision makes banks the most closely monitored of financial intermediaries operating in Australia. This is also true of other industrialised countries, such as the United States and the United Kingdom. The Banking Act of 1959, the Reserve Bank Act of 1959, the Financial Corporations Act of 1974, and the Bank Integrations Act of 1991 empower the Reserve Bank of Australia (RBA) to maintain stabiiity in the financial system as a whole. As one of its primary responsibilities, The Banking Act imposes a duty on the
Corresponding author. Tel.: + l [email protected]
(714) 773 3716; Fax: + l
(714) 773 2161; E-mail:
0927-538X/96/$15.00 Copyright © 1996 Elsevier Science All rights reserved. PII S0927-538X(96)00019-4
422
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Reserve Bank of Australia to protect depositors of banks, l However, a former Governor of the R B A has stated,
"... (the) Banking Act is silent in regard to the priority to be given to depositors. So the legislation is less than a guarantee to depositors of full repayment and is no assurance of the solvency of an individual bank, nor of how the parties would emerge in the event of a winding-up." (Johnson, 1985, p. 572)
The ambiguity arises because of the nature of repayment, and whether this means repayment in full. However, Hogan and Sharpe (1990) assert that there is a public perception that the R B A would not allow depositors to lose in the event of a bank failure. Hogan and Sharpe (1990) suggest this perception is reinforced by: (i) official statements pointing to the undoubted strength and safety of the banking system; and (ii) likely political intervention should small banks appear in jeopardy. Furthermore, Hogan and Sharpe (1990) state,
" T h i s situation may be depicted as the ' w o r s t of both worlds' in that ... (it) extends protection to a large group of depositors ... while, on the other hand, the uncertain degree of protection may not prevent a contagion effect ... there is every prospect of political pressure being exerted with the view to protecting small depositors (and large ones as well), thereby transferring the incidence of the bank's losses onto general taxpayers." (p. 132)
Thus, it would appear that deposits in Australian banks are insured, at least to some degree. Kane and Kaufman (1992) have described the credit enhancement arising from such a system as " i m p l i c i t deposit insurance". 2 However, Australian banks pay no explicit deposit insurance premium as is the case with the banking system in the United States, where banks pay for explicit deposit insurance contracts. The insurance subsidy for Australian banks is granted by the R B A and is paid for, ultimately, by the taxpayers of Australia. The implicit guarantee of deposits in Australian banking is currently under review by the RBA.
t Actually, the Reserve Bank of Australia has only the responsibility for privately-owned banks, though many of the state-owned banks have recently come under the protection of the RBA. Deposits in the Commonwealth Bank of Australia are explicitly protected by the full faith and credit of the Commonwealth Government of Australia. However, this does not alter our investigation in any significant manner as the burden of any subsidisation still lies with the taxpayers of Australia. Therefore, for the remainder of this paper, we use the terms RBA and government interchangeably. z The likelihood of depositor repayment increases substantially for the four "major" banks in Australia, which account for approximately two-thirds of all bank assets in Australia.
S.A. Dennis, A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
423
Therefore, it is important that regulators, banks, and market participants alike understand the value of the deposit guarantee, or alternatively, the government's obligation. To the extent that regulation constrains the activities of banks, a cost of this implicit deposit insurance is already imposed on Australian banks. 3 However, a fallacy lies in arguing that the RBA should not charge a deposit insurance premium because the cost of regulation equals the deposit insurance value. This ignores other benefits of being regulated, such as funding cost advantages and access to a lender of last resort. Moreover, it is unclear whether the employment of regulation by itself is efficient. Perhaps the employment of regulation and some explicit deposit insurance premium is optimal. This paper attempts to determine the degree to which Australian banks are subsidised by the Reserve Bank of Australia for deposit insurance. Using methodology similar to that used for studies of other deposit insurance systems, we determine that there is a substantial subsidy granted to Australian banks. Over the three-year period 1990-1992, our estimates for the value of deposit insurance to Australian banks (alternatively, the government's actuarially fair claim) range from $30.7 million to $3.6 billion. Our estimates employ two methodologies and two potential closure policies of the government. While our estimation period covers a turbulent period in Australian banking, the estimates suggest that the Australian government has a large potential claim in the event of bank failure. The remainder of this paper is organised as follows: Section 2 describes the model employed and Section 3 describes our data. Section 4 provides the empirical results and Section 5 concludes.
2. A model of deposit insurance pricing Merton (1977) was the first to demonstrate that the insurance benefit to financial institutions can be calculated using an option pricing approach. Marcus and Shaked (1984), Ronn and Verma (1986), Pennacchi (1987), Kendall (1992) and others have derived methodologies for empirically examining the value of this deposit insurance. The model is as follows: Consider a bank with B 1 total deposits and B~ other liabilities such that the bank has total debt B = B l + B2. When the terminal value of the bank's assets, V r, is higher than the value of total liabilities, the holders of deposits receive the future value of their deposits. However, if the terminal value of assets does not exceed the value of liabilities, the holders of
3 This point is often argued by Australian banks.
S.A. Dennis, A.B. Sire/Paci[ic-Basin Finance Journal 4 (1996)421-435
424
deposits would receive receive
(Bj/B)V T. 4
Thus, at the end of the period, depositors
where r h is the interest rate paid on deposits. Assuming Vr is exogenous, the insurance premium would be the price of a European put option on the deposits with a strike price equal t o B 1 (if only the principal is insured) or Bj e"" (if the entire future value of deposits is insured). 5 The underlying "asset" price in this case is BI
K' = ~ V , ( l - 6 ) , where ~ is the dividend per dollar of value of total assets paid by the bank during the period. Then, the value of deposit insurance is determined as:
pe"'= B,e""U( y + G,~[t) - V'N( y), where,
ln((Bne'")/V')-(o,f-t)/2 Y= o-~ or
p = B l e ( " ' - " " N ( y + ~,~-t) - V ' e
"iN(y).
When r 1 = r, we have,
p=BiU(y+<,~/-t)-V'e
"'U(y).
(1)
The put equation given in (1) is valid only for the case when the deposit insurance premium is paid by the depositors. In the case when the premium is paid by the bank, the equation should be modified to reflect the reduction in asset value caused by the payment of the premium. In the context of this paper, we recognise that Australian banks do not currently pay the insurance premium. Therefore, we make no adjustments in the estimations. ~ We can use Eq. (1) to determine the value of any deposit insurance subsidisation received by Australian banks. In empirical applications of the above model, both the " t r u e " value of the bank's assets and the variance of returns on those assets are unknown. However, Ronn and Verma (1986) recognise that the equity
a This assumes all debt of the bank to be of equal seniority. 5 We assume that tbe entire future value of deposits is ,guaranteed. ~' Hov~e',er, if the RBA were to begin to charge for explicit deposit insurance, this premium should be reflected in the pricing of deposit insurance. For a discussion, see Kendall (1992).
S.A. Dennis. A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
425
value of the bank can be viewed as a call option on the assets of the bank, written by the debtholders of the bank. Therefore, this gives an equation relating the equity value of the firm to both the true value of the assets and the volatility of returns on those assets. Incorporating the closure rule condition, Ronn and Verma (1986) model the equity value of the bank as: 7
E = VoN ( x ) - p B N ( x - ~,f-T),
(2)
where now l n [ V r / ( pBe"r)] + (o-~2T)/2 x=
Also, Ronn and Verma (1986) use the Merton (1974) equation relating the equity volatility of the bank to the asset volatility of the bank:
o-=
.o;.
(3)
If the bank's shares are publicly traded, both the value of bank equity and the volatility of equity can be obtained. This gives two nonlinear equations (Eq. (2) and Eq. (3)) in two unknowns, which can be solved for the solution pair (V,%). Once the solution pair is obtained, it can be substituted into Eq. (1) to arrive at the deposit insurance premium. Duan (1994), however, points out a shortcoming in the Ronn and Verma (1986) approach. Duan (1994) suggests that if bank assets are assumed to follow a process with constant variance (as Merton's assumes) and bank equity is a call option on bank assets, bank equity must have a nonconstant variance (Merton, 1977). This presents two problems. First, one cannot sample bank equity returns for estimates of bank equity volatility, because equity volatility is stochastic. Second, the Merton (1974) equation relating equity volatility to asset volatility assumes equity volatility is constant and therefore cannot be employed. Duan (1994) offers an alternative methodology which overcomes the shortcoming of the Ronn and Verma (1986) approach. Duan (1994) suggests that the unobserved series of market value of assets and the volatility of assets of the bank can be estimated using a time series of equity values of the bank. Eq. (2) relating the value of assets and asset volatility to equity values can be transformed such
7 The closure rule condition parameter in Eq. (2), p, identifies the point at w h i c h the regulatory authority will close the bank as a percentage of the debt value of the bank. A closure at zero net worth implies # = 1.00. A forbearance policy of 2.5r/i of the b a n k ' s debt level by the regulatory authority implies p = 0.975. More discussion of the closure rule condition in given in Section 3. For a detailed discussion, see Ronn and V e r m a (1986).
426
S.A. Dennis. A.B. Sire / Pacific-Basin Finance Journal 4 (1996) 421-435
that the value of assets is written in terms of the equity value of the bank and the volatility of assets. Then, the transformed log-likelihood function of the time series of equity values can be written as: n-
LE = -
1
2
n-
1
ln(27r) - - - l n r r ,~ . ~, 2
- ~ln(N(ct,)).
-
2o'-
In
---•, , ( ~ , )
-
#
(4)
t=2
This process gives estimates of the value of bank assets, the mean return on assets, and the volatility of returns on assets. The two parameters of interest can then be applied to deposit insurance pricing via Eq. (1).
3.
Data
The study was performed for a sample of eight publicly-traded Australian banks over the period July 1, 1989 to December 31, 1992. ~ The daily stock price series, dividend series, annual report dates, and number of shares outstanding were extracted from the ASX database for the period. Monthly statistics on total deposits, total assets, and total other liabilities, were taken from the Reserve Bank of Australia's Bulletin. In computing the market value of equity, the number of shares outstanding were multiplied by the average daily share price over the week preceding the date on the annual statements of the bank. 9 Because of the thin trading in some Australian stocks, daily stock prices were converted to weekly returns for computing equity volatility. Conversion to a weekly series would perhaps reduce any bias caused by infrequent trading. Equity volatility, required for the Ronn and Verma (1986) methodology was measured over a 52-week period preceding the annual report date for each bank. 10 The same 52-week period was used for the methodology of Duan (1994). i1
s The sample includes: Advance Bank Australia, ANZ Banking Group, Bank of Melbourne, Bank of Queensland, Challenge Bank, Metway Bank. National Australia Bank, Westpac Banking Corporation and their subsidiaries, if" any. We also used the share price at the report date and the average daily share price for the month preceding the report date. The results were similar. m The annual report dates are generally at the end of the month with ABA in May, BML and MWB in June. BQD in August, and the remaining four banks in September. ii While weekly stock prices were used for estimating the market value of assets and the volatility of returns on assets by maximising the log-likelihood equation in (4), total deposits and debt values could only be updated monthly while the number of shares outstanding could only be updated annually.
S.A. Dennis, A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
427
The analysis focuses on two values for the policy parameter, p. We employ a value of 1.00 to represent the scenario in which the RBA closes the bank at examination when the bank's net worth is zero. Studies of the deposit insurance system in the United States suggest that the model should be altered for forbearance on the part of regulators. Ronn and Verma (1986) suggest a forbearance policy of 3% of the bank's liabilities in their sample which is consistent with the FDIC's pricing policy. Gizycki and Levonian (1993) suggest that any closure rule less than 2% of the bank's liabilities in the Australian context is inconsistent with the data of their study. Therefore, we employ 2.5% (p = 0.975) as a second closure rule. There is also the issue of time to maturity of the options. Firstly, there is the question of whether it is valid to assume that the time to maturity for the put option in Eq. (1) is equal to the time to maturity of the call option in Eq. (3). Eq. (1) should have the time to the next examination as the time to maturity, whereas Eq. (3) should have the maturity of the liabilities of the bank as the time to maturity. However, Ronn and Verma (1986) note that it is reasonable to assume, because of the closure powers of the RBA, that the maturity of both options is the next examination of the bank. Second, we must be concerned with the exact timing of the next examination of the bank. If the time to the next examination is chosen incorrectly, the value of deposit insurance will be mispriced. Ronn and Verma's Table 2 demonstrates the behaviour of deposit insurance when the time to maturity is varied between 1 / 4 years and 5 years. The premium is an increasing function of the chosen time to maturity. Ronn and Verma note the problems associated with determining the exact time to the next examination in the United States. US banks submit information on a quarterly basis, but this information is largely unaudited. Determining the time of the next examination is perhaps more difficult in Australia, given that prudential regulation occurs as an ongoing, consultative process. Banks are required to produce statistical information at various frequencies, from daily to annually. However, much of the more frequently disclosed information is unaudited, though the accounting systems used to produce the data are audited. 12 Therefore, as with studies of the American deposit insurance system, the timing of the next examination is relatively difficult to ascertain. We assume that the time to the next 13 examination is one year.
L2From discussions with RBA staff. ~3Our reasoning is similar to Ronn and Verma (1986). Using time periods other than one year creates difficulties in annualising the premium. Most studies of deposit insurance assume one year as the time to examination, perhaps because it is more straightforward to discuss an annual premium.
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4. Empirical findings Tables 1 and 2 present the results for the deposit insurance premium employing the two closure rules. Table 1 reports the values of deposit insurance assuming a closure rule of 1.00 and Table 2 reports values assuming a closure rule of 0.975. In both tables, the deposit insurance premium is given in both dollars (millions) and basis points (1% = 0.01). The standard deviation of the returns on assets is given and, for estimates using Duan's methodology, the standard error for the estimate of the volatility of assets, S.E.(O'A), is also given (Duan, 1994). The market value of assets, the book value of assets, and the level of deposits are reported in millions of dollars. At the bottom of each section in the tables, the average values for the deposit insurance premium in basis points and the standard deviation of returns on assets are given. Also, the total values for the deposit insurance premium in dollars, the market value of assets, the book value of assets, and the level of deposits are given. Table 1 reports the value of deposit insurance employing a closure rule of 1.00. The left-hand column denotes the bank symbol and the year of the study. The next column provides the Ronn and Verma (1986) estimates of deposit insurance. Challenge Bank, Westpac, and ANZ received the largest insurance subsidies in 1990, while the other five banks in the sample received negligible subsidies. Again in 1991 and 1992, ANZ and Westpac received substantial insurance subsidies from the RBA. This time period corresponds to the loan quality problems both these banks were experiencing. NAB, Metway, Advance Bank, and Bank of Melbourne received little insurance subsidies over the three-year period. The total amount of insurance subsidy for the eight banks in our sample was approximately $22 million in 1990. In 1991, that figure escalated to $40.2 million, mostly due to the subsidies provided Westpac and ANZ. In 1992, the insurance subsidy for these eight banks decreased to $17.7 million. The estimates of the volatility of returns on assets are roughly 4% to 5% per annum. The estimate increases from 1990 to 1991, but then decreases in 1992 to a level just below the 1990 figure of 4.38%. The estimate for the market value of assets of the sample banks is well below the book value. The period under examination coincides with a general depression in the Australian economy, with severe depression in many residential property prices. Some of the banks in the sample are known to have had substantial exposures to the property market collapse. The next section of Table 1 provides the estimates for deposit insurance employing Duan's methodology (Duan, 1994). These estimates are much higher than the estimates using Ronn and Verma's (1986) methodology. The higher estimates for the value of deposit insurance using Duan's (1994) methodology, as compared to Ronn and Verma (1986), is also noted by Duan and Yu (1995) for the case of the deposit insuring agency in Taiwan. The wide divergence in deposit insurance premia in our study can be attributed to the estimate of asset volatility of
S.A. Dennis, A.B. Sire~ Paci[ie-Basin Finance Journal 4 (1996) 421-435
429
the bank. The estimates for the market values of bank assets are very similar using the two methodologies. However, Duan's (1994) estimates of the volatility of assets are approximately twice the Ronn and Verma (1986) estimates, on average. Duan and Yu (1995) report that both the market value of assets and the volatility of returns on assets are significantly lower for banks in Taiwan when employing Ronn and Verma' s (1986) methodology. The relative merits of the two approaches should perhaps be mentioned here. While Ronn and Verma (1986) require the volatility of equity to be nonstochastic, an assumption which is inconsistent with the model, Duan's (1994) methodology is susceptible to measurement errors. In the current context, the obvious sources of measurement errors are the monthly updates of total deposits and debt values and the annual update of the number of shares outstanding. Introduction of an error term in Eq. (2) would require a modification of the transformed log-likelihood function in Eq. (4). Ignoring this modification would lead to measurement errors in the market value of assets and, subsequently, a biased estimate of the volatility of returns on assets. As is well known, the value of an option is quite sensitive to the volatility of the underlying. With volatility estimates roughly twice the Ronn and Verma (1986) estimates, it is not surprising that the Duan (1994) methodology produces much larger values for deposit insurance. If the Duan (1994) methodology is the "most correct", the Australian taxpayers should be concerned. The estimated total deposit insurance subsidisation in 1990 is $203.1 million. In 1991, the estimate rises to $301.9 million, while in 1992, the estimate for deposit insurance for the eight banks in our sample is roughly $1.7 billion. The very large subsidy in 1992 is mostly attributable to ANZ. who is known to have experienced severe loan quality problems during this period. To estimate the insurance subsidy |br the entire Australian banking system, we determine the total market share of deposits for these eight banks as a percentage of total Australian bank deposits. These figures were 54.37%, 56.15%, and 57.29% for 1990, 1991, and 1992, respectively. Assuming the risk of the eight banks in our sample to proxy the risk for the Australian banking system, we can determine the total amount of subsidy for the banking system through the relative market share of our sample. Multiplying the subsidy for the eight banks in our sample in 1990 by the inverse of 54.37%, we find that Australian banks were subsidised for $40.7 million ($373.6 million) in 1990 using Ronn and Verma's (Duan's) methodology. Similarly, we find that the Australian banking system received a subsidy of $71.4 million ($537.7 million) in 1991 and $30.7 million ($2.9 billion) in 1992. Table 2 depicts the same analysis; however, the policy parameter is assumed to equal 0.975, which is perhaps closest to the Australian closure rule as determined by Gizycki and Levonian (1993). The decrease in the policy parameter from 1.00 to 0.975 (a forbearance policy introduction of 2.5% of the liabilities of the bank) has the effect of increasing the estimates of deposit insurance. The estimate of the
0.0182 0.0370
0.244E-04 0.759E-04
0.153 2.261
ABA ANZ
1992
0.0516
0.237E-03
0.0438
0.708E 03
0.0214 0.0805 0.0221 0.0677 0.0171 0.0191 0.1030 0.0820
0.0193 0.0697 0.0155 0.0564 0.0501 0.0244 0.0454 0.0699
0.209E-04 0.105E-03 0.743E-07 0.116E-06 0.525E-02 0.258E-04 0.120E-08 0.264E-03
0.835E-04 0.823E-03 0.557E-04 0.817E-05 0.582E-04 0.263E-06 0.175E-04 0.850E-03
0.471 17.189 0.208 0.004 0.171 0.001 0.367 21.873 40.283
0.103 1.972 0.000 0.000 14.523 0.046 0.000 5.385 22.028
ABA ANZ BML BQD CLG MWB NAB WBC Total Average
1991
/ 990 ABA ANZ BML BQD CLG MWB NAB WBC Total Average
6852 34527
6287 26725 4045 662 3142 2263 30582 31965 105672
5377 23390 3419 396 3025 1997 26724 26093 90420
MV assets
35.683 1513.6
122.20 18.910 51.975 3.659 2.204 19.701 0.000 83.273 301.922
40.580 11.293 49.852 1.7645 11.317 66.352 1.049 20.915 203.123
0.569E-02 0.508E-01
0.719E-02
0.217E-01 0.905E-03 0.139E-01 0.730E-02 0.749E-03 0.969E-02 0.227E-08 0.324E-02
0.912E-02
0.826E-02 0.599E-03 0.158E-01 0.613E 02 0.409E-02 0.370E-01 0.519E-04 0.102E-02
Premium bp
Duan (1994) methodology
era
Premium S
Premium bp
Ronn and Verma (1986) methodology
Premium s
Table 1 Risk-adjusted deposit insurance premium, p = 1.0 ~
0.05418 0.21775
0.09151
0.10301 0.07219 0.08513 0.16545 0.03469 0.08643 0.07083 0.11433
0.09864
/).06680 0.08565 0.09811 0.16738 0.04791 0.15878 0.07958 0.08491
0.00401 0.01305
0.00480 0.00519 0.00516 0.00996 0.00256 0.00369 0.00599 0.01063
0.00268 0./)0437 0.00630 0.00798 0.00300 0.00978 0.00713 0.00500
S.E.((~)
6854 34489
6287 26141 4047 662 3196 2264 31446 32522 106565
5382 23333 3419 396 3035 1996 26601 26068 90230
MV assets
7185 58755
6441 49299 4295 677 3305 2393 44512 54387 165309
5559 43457 3696 414 3277 2037 42635 46218 147293
BV assets
6271 29805
5640 20893 3729 501 2942 2034 20946 25740 82425
4914 18840 3149 288 2766 1793 20231 20421 72402
Deposits
7" 4~
4:*
2
2
C,Z
e~
1.831 0.000 1.638 0.000 0.000 11.771 17.655
0.0449 0.0768 0.0297 0.0188 0.0450 0.0513 0.0402
0.414E-03 0.804E-06 0.531E-03 0.184E-06 0.115E- 13 0.418E-03
0.183E-03
4955 838 3373 2861 33785 32147 119337
23.383 2.0t)7 8.646 16.235 0.000 83.169 1682.723 0.966E-02
0.529E-02 0.340E-02 0.281E-02 0.636E-02 0. l 16E-07 0.296E-02 0.09948
0.10340 0.14244 0.04430 0.09330 0.06545 0.07502
0.00577 0.00763 0.00289 0.00821 0.00609 0.00513
5171 782 3373 2952 33800 32145 119566
5083 836 3406 2995 51692 54673 184625
4424 591 3082 2553 23771 28146 98643
a Premium is given in both dollars (millions) and basis points (1% = 0.01 ). The market value of assets, book value of assets, and deposits are given in millions. S.E.(O" a ) is the standard error of the estimate of volatility of assets using Duan's (1994) methodology.
BML BQD CLG MWB NAB WBC Total Average
7" 4~
4~
~z
7"
0.102E-02 0.574E-03
1992 ABA ANZ 0.0199 0.0389
0.0540
0.116E 02
6.428 17.118
0.0242 0.0844 0.0241 0.0690 0.0206 0.0196 0.1050 0.0859
0.0472
0.275E 02
0.172E-02 0.203E-02 0.117E-02 0.307E-04 0.219E 02 0.327E-04 0.414E-04 0.205E-02
9.681 42.319 4.37 0.015 6.445 0.1167 0.868 52.832 116.597
0.0208 (/.(/716 0.0159 0.0575 0.0677 0.0255 0.0463 (}.(t724
0.780E-03 0.322E-03 0.330E-04 0.801E-06 0.196E-01 0.504E-03 0.2(X)E-07 0.768E-03
1991 ABA ANZ BMI, BQD CLG MWB NAB WBC Total Average
3.832 6.072 0.104 0.000 54.274 0.904 0.000 15.679 80.865
1990 ABA ANZ BML BQD CLG MWB NAB WBC Total Average
6697 33754
6147 2616 t 3954 649 3074 2211 30037 31292 103523
5254 22906 3339 388 2943 1952 26196 25544 88521
MV assets
74.778 1749.800
180.330 38.760 8(1.104 4.566 9.631 30.931 0.000 125.32 469.642
72.399 20.378 72.817 2.231 26.779 83.240 2.465 39.554 319.863
0,119E-01 0.587E-01
0. I 10E-01
0.319E-01 0.186E-02 0.215E-01 0.91 l E-02 0.327E-02 0. t52E-01 0.106E 07 0.487E-02
0.131E-01
0.147E-01 0. t 08E-02 0.231E-01 0.775E-02 0.968E-02 0.464E-0 I 0.122E-03 0.194E 02
Premium hp
Premium ~
o-~
Premium s
Premium bp
Duan (1994) methodology
Ronn and Verma (1986) methodology
Table 2 Risk-adjusted deposit insurance premium, p = 0.975 a
0.05444 0.21791
0.09212
0.10800 0.07225 0.08551 0.16418 0.03499 0.08634 0.07139 0. t 1430
0.09845
0.06686 0.08484 0.09869 0.16671 0.04800 0.16146 0.0798 t 0.08519
0.00405 0.01312
0.00505 0.00526 0.00524 0.00978 0.00258 0.00369 0.00606 0.01067
0.00269 0.00424 0.00643 0.00798 0.00303 0.01029 0.00712 0.00505
S. E.( ~ )
6691 33708
6141 25592 3951 649 312(/ 2212 30894 31835 104394
5255 22847 3339 388 2963 1950 26073 25514 88329
MV assets
7185 58755
6441 49299 4295 677 3305 2393 44512 54387 165309
5559 43457 3696 414 3277 2037 42635 46218 147293
BV assets
6271 29805
5640 20893 3729 5()1 2942 2034 20946 25740 82425
4914 18840 3149 288 2766 1793 2/1231 20421 72402
Deposits
']"
~,
4a
~.
5"
a:' 6a
.~ ~"
~"
e~
t'J
8.763 0.002 13.536 0.068 0.000 47.629 93.544
0.0487 0.0782 0.0357 0.0193 0.0459 0.0549 0.0427
0.198E-02 0.302E 05 0.439E-02 0.268E-04 0.468E- 12 0.169E-02
0.121E-02
4845 822 3298 2795 33169 31438 116817
36.354 2.657 23.078 24.369 0.001 155.76 2066.797 0.133E 01
0.822E-02 0.450E 02 0.749E-02 0.965E-02 0.550E-07 0.553E-02 0.09934
0.10336 0.14214 0.04442 0.09144 0.06586 0.07518
0.00579 0.00766 11.00293 0.00776 0.00618 0.00515
5053 769 3294 2884 33184 31421 1171)04
5083 836 3406 2995 51692 54673 184625
4424 59 I 3082 2553 23771 28146 98643
Premium is given in both dollars (millions) and basis points ( I ~7, = 0.01 ). The market value of assets, book value of assets, and deposits are given in millions. S . E . ( ~ ) is the standard error of the estimate of volatility of assets using Duan's (1994) methodology.
BML BQD CLG MWB NAB WBC Total Average
t~
4~
434
S.A. Dennis, A.B. Sim / Pacific-Basin Finance Journal 4 (1996) 421-435
market value of assets is generally higher than the case of no forbearance. However, the estimate of the volatility of assets is also higher, thus producing a higher estimate for deposit insurance. The total deposit insurance subsidies for the Australian banking system in 1990, 1991, and 1992 are $148.2 million ($588.3 million), $209.1 million ($836.4 million), and $164.1 million ($3.61 billion), respectively, employing Ronn and Verma's (Duan's) methodology.
5. Discussion
There is ambiguity with respect to the insurance coverage Australian depositors receive. Although there is no explicit regulation stating that deposits in Australian banks are guaranteed in the event of bank failure, there is some non-zero probability that all depositors will be covered. Statements by public officials concerning the safety of the Australian banking system have kindled a public perception that such insurance exists. Recent actions by the RBA in bank failure cases would also tend to strengthen the argument that deposit insurance exists. In the debacle concerning State Bank of Victoria, all liability holders were protected as the RBA positioned the (then fully-government-owned) Commonwealth Bank to acquire the State Bank of Victoria. 14 In essence, this is complete deposit insurance. To the extent that deposit insurance exists in Australia, Australian banks are subsidised for such insurance because of the lack of premiums charged by the RBA. This paper determines the value of this implicit deposit guarantee in three turbulent years in Australian banking. We have assumed full insurance for depositors in Australian banks. To the extent that deposits have less than a full guarantee, we have estimated upper bounds for the cost of deposit insurance to the taxpayers of Australia. However, our results show that the value of the deposit guarantee may be substantial. The depositor protection provisions of the Banking Act are currently under review by RBA supervisors with some market participants arguing that the policy of "constructive ambiguity" for deposit insurance needs substantial review to determine who bears the risk of bank default (see Rogers, 1994, p. 28). One view canvassed by Rogers is that deposit insurance represents an unwarranted regulation for banks and that elimination of explicit government guarantees would "open up competition in the deposit market". However, Diamond and Dybvig (1983) suggest that the removal of all depositor protection provisions could lead to widespread financial panics.
14This case is very interesting in that the Labor Party of the state of Victoria contacted the Federal Labor Party for assistance in the debacle. Eventually, the Federal Labor Party coerced the Commonwealth Bank to acquire the State Bank of Victoria. The Victorian Governmentultimately assumed the losses of the State Bank of Victoria.
S.A. Dennis, A.B. Sim / Pac~c-Basin Finance Journal 4 (1996) 421-435
435
W e advocate a specific policy stance by the R B A regarding deposit insurance in Australia. Such a rule w o u l d eliminate any ambiguity depositors might have. To the extent that depositors charge a risk p r e m i u m c o m m e n s u r a t e with the uncertainty surrounding deposit insurance, the cost to banks o f acquiring funds m a y perhaps be reduced. Thus, the cost to individual banks of i m p o s i n g an explicit deposit insurance system is perhaps less than the full cost o f the insurance premium.
Acknowledgements This paper has benefitted f r o m helpful c o m m e n t s on earlier drafts by D a v i d Thurston, participants at the U n i v e r s i t y of M e l b o u r n e A c c o u n t i n g and Finance seminar series and at the Seventh Annual Australian Finance and Banking Conference, the editor, and a n o n y m o u s referees.
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