- Email: [email protected]
Banks' changing incentives and opportunities for risk taking
Journalof ELSEVIER
Journal of Banking & Finance 21 (1997) 509-527
BANKING & FINANCE
Banks' changing incentives and opportunities for risk taking Tina M. Galloway a,*, Winson B. Lee b, Dianne M. Roden c a Unit,ersity of Miami, Coral Gables, FL 33124, USA b Universi~' tff'Colorado at Denver, Denver, CO 80217, USA c Indiana Unit,ersi~, at Kokomo, Kokomo, IN 46904, USA
Received 29 September 1995; accepted 20 September 1996
Abstract This paper investigates the deterioration of the banking industry's risk-control system during the 1980s and the time-varying relation between a bank's ex-ante risk-taking incentives and its ex-post risk-taking behavior over the period 1977-1994. We document that banks with high charter value imposed self-discipline on risk-taking behavior at all times. In contrast, banks with low charter value assumed significantly more risk beginning around 1983, and this behavior continued into the early 1990s. These findings have several important policy implications. JEL classification." G21 ; G28 Keywords: Risk taking; Charter value; Regulation
1. Introduction
Since the late 1970s, the banking industry has undergone dramatic change, switching first from a regulated environment to broad deregulation in the early
* Corresponding author. University of Miami, Department of Finance, P.O. Box 248094, Coral Gables, FL 33124-6552; (305) 284-1883; Fax (305) 284-4800; Intemet: [email protected] 0378-4266/97/$17.00 Copyright © 1997 Elsevier Science B.V. All rights reserved. PHS0378-4266(96)00052-0
510
T.M. Galloway et aL / Journal of Banking & Finance 21 (1997) 509-527
1980s, and then back toward a regulated environment in the early 1990s 1. To maintain a sound and stable banking environment, an effective regulatory system must control not only the bank's incentives but also its opportunities to take excessive risk. Much of the current regulatory structure was developed on an ad hoc basis in response to developments and crises as they occurred. This paper investigates the deterioration of the banking industry's risk-control system during the 1980s and the time-varying relation between a bank's ex-ante risk-taking incentives and its ex-post risk-taking behavior over the period 1977-1994. A fixed-rate deposit insurance premium was in place until the FDICIA mandated a change to risk-adjusted premiums effective January 1993. Merton (1977) formulates fixed-rate deposit insurance as a put option that gives wealth-maximizing banks an incentive to increase risk to obtain a larger insurance subsidy. Under such a policy, banks are not penalized for risk-taking behavior; instead, they can issue insured deposits near the risk-free rate to finance risky ventures and are allowed to keep most of the upward potential from the investment while transferring most of the downside risk to the Federal Deposit Insurance Corporation (FDIC). To control risk-taking behavior, regulators have utilized two traditional risk-control devices: bank charter value and regulatory supervision. Bank charter value, i.e., the value of the right to continue to operate, is created through regulatory restrictions on entry and competition and is identified as a bank's self-imposed risk-discipline device (Buser et al., 1981; Marcus, 1984; Keeley, 1990). A bank with a high charter value has an incentive to avoid a high-risk strategy, because the owners of the bank cannot sell the charter if the bank is declared insolvent. In line with this argument, Keeley (1990) finds that banks with higher charter value follow a lower-risk strategy by holding more capital relative to assets. However, charter value alone does not eliminate the agency problem between the FDIC and banks. If charter value decreases due to bank-specific or industrywide events, the potential loss of charter value may no longer function as a risk-taking disincentive. In this case, following a higher-risk strategy, either by decreasing capital relative to assets or by increasing asset risk, may produce an expected gain in the value of the bank's deposit insurance subsidy that is larger than the expected loss of its charter value (Keeley, 1990). To mitigate the shortcoming of charter value as a risk-control device, the FDIC and other bank regulators impose risk-control regulations to further restrict the risk level in the banking industry. These agencies regulate banks through periodic
l Deregulatory legislation includes the Depository Institutions Deregulation Monetary Control Act (DIDMCA) of 1980 and the Garn-St. Germain Depository Institutions Act of 1982. Re-regulatory legislation includes the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 and the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991.
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
511
monitoring and timely foreclosure of insolvent banks. In January 1993, the FDIC began using a risk-based premium structure that assesses varying premiums across nine risk categories. Some critics argued, however, that the spread in premiums between the safest and riskiest banks was insufficient to seriously dissuade risky banks from conducting moral hazard behavior (Kaufman, 1994) 2. On balance, the two risk-control devices of charter value and regulations are complementary. Operating under risk-control regulations, banks with low charter value have some risk-taking incentives, but have limited opportunities to conduct moral hazard behavior. Meanwhile, the remaining banks with high charter value and limited risk-taking incentives operate in a self-control mode, allowing regulators to concentrate their limited resources on the small group of high-risk banks. Before the mid-1980s, charter value and regulations were jointly successful in restricting banks' opportunistic behavior, as illustrated by the small number of bank failures in the FDIC's early history 3 After this time, however, the effectiveness of these risk-control devices was seriously impaired. Due to increased competition resulting from deregulation, technological advances, and financial innovations in the banking industry beginning in the early 1980s, bank charter values fell significantly and banks operated with a lower degree of regulatory protection. Further, the enforcement of monitoring and foreclosure of problem banks was relaxed when the FDIC was decapitalized at the same time as the number of problem banks increased. We hypothesize that these market and regulatory developments gave banks increased risk-taking incentives and opportunities beginning in the mid-1980s, and that banks with higher incentives assumed more risk when given the opportunity. We also investigate whether the re-regulatory environment of the early 1990s helped to control risk-taking behavior. Using a sample of 86 commercial banks over 1977-1994, we examine the time-varying relation between the banks' ex-ante risk-taking incentives and their ex-post risk-taking behavior 4. We find
2 In January 1993, premiums per $100 of insured deposits ranged from 23¢ for well-capitalized, healthy banks to 31¢ for under-capitalized banks with substantial supervisory problems. In January 1996, the premiums were reduced and now range from nearly zero to a maximum of 27¢ per $1(10 of insured deposits. 3 For example, according to FDIC Annual Reports, 1143 banks failed during the period 1983-199(I, more than five times the number (228) of bank failures that occurred during the previous 38 years (1945-1982). a Keeley (1990) finds a contemporaneous positive relation between charter value and bank capital, and thus a negative relation between charter value and risk. However, a contemporaneous relation may simply reflect a bank's superior performance and not necessarily its intentions to take on less risk (see Galai and Masulis, 19761. Thus, we examine the relation between the bank's ex-ante risk-taking incentives and ex-post risk-taking behavior. Further, Keeley implicitly assumes the relation between charter value and risk-taking is constant over time. Given the changing effectiveness of regulation over time, we also test the time-varying relation between ex-ante risk-taking incentives and ex-post behavior.
512
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
that the average market-to-book equity ratio, a proxy for charter value, fell significantly during the period analyzed. Banks with low ex-ante charter value increased ex-post risk significantly beginning in the mid-1980s. In contrast, banks with high ex-ante charter value maintained a low-risk strategy at all times. We also find that banks with low charter value continued to take on more risk than banks with high charter value after regulations were tightened in the early 1990s. These findings further the understanding of the conditions that trigger bank risk-taking behavior, and are useful for deposit insurance and regulatory policy reform. The paper is organized as follows. In the next section, we discuss bank charter value and the enforcement of risk-control regulations. We then develop hypotheses concerning banks' changing incentives for risk taking. In Section 3, we describe the sample and empirical methods used to test the hypotheses. In Section 4, we present the empirical results. Finally, in Section 5 we present the conclusions and policy implications.
2. Predictions for bank risk-taking behavior 2. l. Bank charter value
Bank charter value is the expected amount of future profits arising from entry barriers and branching restrictions that limit competition. Collins et al. (1994) state that the charter represents the ultimate unbooked growth option because it permits the bank to operate. Because the charter value is realized only if the bank survives, Marcus (1984) advocates that bank charter value affects risk-taking incentives. Hence, a bank with a high charter value is less likely to take excessive risk that jeopardizes its survival and, thus, its stream of future cash flows. Because charter value is an intangible asset that represents a bank's growth opportunities, Tobin's q, defined as the ratio of the market value of a firm to the replacement cost of its assets, is an attractive theoretical measure to capture charter value. Lindenberg and Ross (1981) propose a complex estimator of q to measure monopoly rent in non-banking industries. However, Chung and Pruitt (1994) and Perfect and Wiles (1994) find that empirically simpler estimators are highly correlated with the Lindenberg and Ross estimator. Thus, we use a simple estimator of q, the market-to-book equity ratio, as a proxy for charter value 5 Because a bank's assets include assets-in-place and unbooked assets such as the charter value, the numerator of the market-to-book equity ratio should reflect the
5 Keeley (1990) uses a market-to-book asset ratio as a proxy for charter value. Collins et al. (1994) use a market-to-book equity ratio as a proxy for growth opportunities, while G a v e r and G a v e r (1993, 1995) use both a market-to-book equity and a market-to-book asset ratio (correlation - 0.47).
T.M. Galloway et al./Journal of Banking & Finance 21 (1997) 509-527
513
capitalized value of the bank charter, and the denominator should not. Thus, the higher the charter value, the higher the market-to-book equity ratio 6 We expect to observe a decrease in charter value beginning in the mid-1980s because of increased competition resulting from market and regulatory developments. For example, deregulation in the early 1980s allowed thrifts and credit unions to offer similar products and compete directly for the same customers. Further, technological advances, such as the automatic teller machine and telephone banking, and the erosion of interstate banking expansion restrictions moved the competition toward a national level. Finally, innovations such as money market mutual funds caused banks to lose deposits, while junk bonds and the opening of global markets provided loan customers with new financing alternatives. Due to the move back toward a regulated environment that began with FIRREA in 1989, we might expect bank charter values to increase and risk-taking incentives to decrease in the early 1990s. However, many of the market forces keeping competition at a high level were still in place, and the spread of only 8¢ in risk-adjusted premiums may have been insufficient to dissuade risky banks from conducting moral hazard behavior.
2.2. The enforcement of risk-control regulations Regulators minimize bank risk-taking opportunities by imposing regulations such as risk-based monitoring and timely foreclosure of insolvent banks. A new bank must satisfy minimum capital requirements in order to be granted a charter and deposit insurance. The FDIC strives to closely monitor the amount of capital. Given the limited resources of the FDIC, regulations are most effectively enforced if the total number of problem banks is small. Conditional on Marcus' (1984) prediction, the enforcement of risk-control regulations is most effective if the average bank charter value is relatively high. Given the market and regulatory developments of the early 1980s, a decrease in charter value and thus an increase in the number of problem banks in the mid-1980s is expected. Thus, we expect a contemporaneous weakening of the FDIC's financial strength and its ability to enforce risk-control regulations. However, some strengthening is expected to occur in the 1990s given the move back toward a regulated environment. FIRREA (1989) was enacted to reform, recapitalize, and consolidate the federal deposit
6 One difficulty in using the market-to-book equity ratio to proxy for charter value is that the numerator may reflect the capitalized value of not only charter value but also other sources of unbooked capital. Kane and Unal (1990) develop a model to estimate two sources of a bank's hidden capital: unbookable off-balance-sheet items and misvaluation of bookable on-balance-sheet items. Applying Kane and Unal's procedure to our sample of banks, we find that unbooked items, such as charter value, contribute more to the market value of equity than does undervaluation of on-balance-sheet items.
514
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
Table 1 Descriptive statistics for the FDIC's financial condition
Year
Problem banks to insured banks (%)
On-site exams to insured banks (%)
Problem bank assets to insured bank assets (%)
FDIC losses to insured bank assets (%)
Ratio of Bank Insurance Fund to total insured deposits
1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
2.6 2.4 2.0 1.5 1.5 2.6 4.4 5.8 7.9 10.5 11.5 10.7 8.7 8.5 9. l 7.5 4.3 2.5
48.3 51.9 50.2 45.5 N/A 38.9 N/A 23.1 20.4 22.5 26.7 30.5 29.2 33.1 36.9 42.0 47.1 41.4
N/A N/A N/A N/A N/A N/A N/A 9.1 8.7 11.4 12.0 11.2 7.2 12.1 17.8 13.2 7.3 1.0
0.0002 0.0006 0.0006 0.0017 0.0383 0.0523 0.0609 0.0596 0.0369 0.0586 0.0674 0.2195 0.1856 0.0830 0.1827 0.1130 0.0158 0.0035
1.15 1.16 1.21 1.16 1.24 1.21 1.22 1.19 1.19 1.12 1.10 0.80 0.70 0.21 (0.36) (0.01) 0.69 1.15
Source: FDIC Annual Reports and the Statistical Abstract of the United States. N / A = not available.
insurance system. The legislation resulted in the higher standards and improved reporting. FDICIA (1991) required early structured intervention and resolution by regulators, and introduced risk-based insurance premiums. Table 1 reports descriptive statistics for the FDIC's condition over the period 1977-1994. As Table 1 shows, the ratio of problem banks to insured banks rises from 3% in 1977 to around 11% in the late 1980s, but falls back to 3% by 1994. The ratio of problem bank assets to insured banks assets exhibits a similar pattern over time. As for costs of resolution, the ratio of FDIC losses to insured bank assets increases from 0.0002% in 1977 to around 0.2% in the late 1980s, and decreases to 0.0035% in 1994. Meanwhile, the ratio of the Bank Insurance Fund (BIF) to total insured deposits falls from approximately 1.2 in the late 1970s to 0.2 in 1990, but rises to 1.2 by 1994. The ratio of on-site audits to insured banks exhibits a similar pattern over time 7. Thus, the data in Table 1 suggest first a weakening of the monitoring
7 The advancement of computer technology, the expanded amount of bank-specific information reported to the FDIC, and the improved accuracy of bank prediction models may have increased the power of off-site monitoring, thus reducing the frequency of on-site monitoring necessary to achieve the same degree of control.
T.M. Gallowayet al. / Journal of Banking & Finance 21 (1997) 509-527
515
system and an increase in the ability of banks to conduct moral hazard behavior without detection during the 1980s, and then some reversal of this weakening in the early 1990s. 2.3. Hypothesis development
We now offer two hypotheses regarding bank risk-taking incentives and behavior under different regulatory regimes characterized by varying degrees of effectiveness of the risk-control devices of charter value and regulations. First, when these risk-control devices are jointly effective, i.e., average bank charter value is relatively high and the FDIC is equipped with solid financial resources, banks with high charter value, in fear of losing future cash flows, have no incentives to assume more risk. Further, the small number of banks with low charter value and high risk-taking incentives have no opportunities to assume more risk because the FDIC intensely monitors them, and forecloses them when necessary. In particular, we hypothesize: HI: When bank charter value and risk-control regulations are jointly effective, ex-post risk-taking behavior is limited and no different for banks with high and low ex-ante risk-taking incentives. Second, due to increased competition resulting from market and regulatory developments, average charter value for banks is expected to decrease significantly beginning in the mid-1980s. Such a reduction in charter value reduces banks' self-control and increases their risk-taking incentives. Given a contemporaneous financial weakening of the FDIC, regulators are unable to perform their monitoring and foreclosure roles effectively. Hence, banks with low charter value and high risk-taking incentives have expanded opportunities to assume more risk. However, banks with high charter value and low risk-taking incentives continue to maintain a low-risk profile. Thus, we hypothesize: H2: When bank charter value and risk-control regulations are jointly ineffective, ex-post risk-taking behavior is higher for banks with high ex-ante risk-taking incentives than for banks with low ex-ante risk-taking incentives. Finally, due to the move back toward regulation in the early 1990s, we expect a strengthening of regulators' abilities to perform monitoring and foreclosure. We also expect charter values to increase. If charter values rise sufficiently and risk-control regulations are strengthened sufficiently, then we expect to find support for hypothesis H1 during the 1990s. However, if the improvement in charter values and the regulatory system are insufficient, we expect to find support for hypothesis H2 during the 1990s.
516
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
3. The sample and empirical methods The sample includes commercial banks and bank holding companies. Data are collected for each bank from the daily CRSP database and from S&P Stock Reports over the period 1977-1994 8. Appendix A contains the names of the 86 banks in the final sample. Although the sample size is small compared to the population of banks and bank holding companies, the total assets of the sample banks account for 45-55% of the total assets of the approximately 14,000 federally-insured commercial banks during the sample period.
3.1. Regulatory regimes We divide the sample period of 1977-1994 into four regulatory regimes characterized by varying degrees of effectiveness of the risk-control devices of charter value and regulations. The pre-deregulatory regime includes 1977-1979, the deregulatory regime covers 1980-1982, the post-deregulatory regime covers 1983-1989, and the re-regulatory regime includes 1990-1994 9. We designate 1980-1982 as the deregulatory regime due to several significant events affecting bank activity and interest rates. For example, in late 1979, the Federal Reserve changed its monetary policy operating targets, resulting in increased volatility in interest rates. Further, Congress passed two major deregulation bills: DIDMCA in 1980 and the Garn-St. Germain Depository Institutions Act in 1982. The early 1980s also saw the beginning of the erosion of intrastate and interstate banking restrictions. We designate 1990-1994 as the re-regulatory regime due to the passage of FIRREA in August 1989 and FDICIA in late 1991 J0
8 It is possible the sample contains a survival bias. However, assuming most of the banks excluded from the sample have low charter value and high risk, this exclusion would bias the analysis against finding a significant relation. Hence, the sample restriction actually provides a more stringent test of our hypotheses. 9 Brickley and James (1986) separate the period 1976-1979 from 1980-1982 in their study of changing insolvency rules. Kane and Unal (1988) study the variability of financial institution risk over 1975-1985, and find switch points in 1977, 1979, and 1982. Saunders et al. (1990) study bank ownership and risk taking, and define three regimes: 1978, 1979-1982, and 1983-1985. Collins et al. (1994) investigate banks' investment opportunities and corporate policy choices, and define pre- and post-deregulatory periods of 1977-1979 and 1983-1985. Finally, Crawford et al. (1994) compare CEO pay and bank performance during a 1976-1981 regulation period and a 1982-1988 deregulation period. l0 We use the dummy variable method of structuring a Chow test to confirm that the four regulatory regimes have different slope and intercept coefficients in our model relating risk-taking behavior to risk-taking incentives. We use a general test of linear restrictions to test the null hypothesis that the coefficients are the same between each pair of regimes. In each case, the null hypothesis of equal coefficients is rejected at the 0.01 significance level.
T.M, Galloway et al./ Journal of Banking & Finance 21 (1997) 509-527
517
3.2. Empirical model We estimate the following ordinary least squares (OLS) regression model to test for a relation between ex-post risk-taking behavior and ex-ante risk-taking incentives: SDRETj, = 130 +/31 *MKT/BOOKj,,_~ +/32 *OPLEVj. , +/33 * CAPITALj,t-i +/34 * LNREALSIZEj,,_ 1 +/35 * HIGHRISKi,t i
+/36 * H I G H R I S K * M K T / B O O K j . t - 1
+ Ejt
(1)
where, for bank j, SDRET is the ex-post (year t) annual standard deviation of weekly equity returns; M K T / B O O K is the ex-ante (year t - 1) market-to-book equity ratio; OPLEV is the ex-ante operating leverage; CAPITAL is the ex-ante equity capitalization ratio; LNREALSIZE is the natural logarithm of the ex-ante real market value of shares outstanding (in millions of 1977 dollars); HIGHRISK is a dummy variable equal to one if the bank has high risk-taking incentives as indicated by an ex-ante market-to-book equity ratio less than one, zero otherwise; and ~ is a random error term for year t. The variables in Eq. (l) are discussed below.
3.3. Dependent and independent variables Similar to Saunders et al. (1990), who investigate the relation between bank risk taking and bank ownership structure, we emphasize a capital market assessment of bank risk. Specifically, we use the annual standard deviation of the bank' s weekly equity returns (SDRET) as our measure of bank risk. We also use the same control variables as Saunders et al. (1990), namely, operating leverage, equity capitalization, and size. We use the ratio of book value of fixed assets to total assets as a proxy for operating leverage, and the ratio of book value of equity to total assets as a proxy for capitalization or financial leverage. These two variables are expected to be, respectively, positively and negatively related to risk (Hamada, 1972; Lev, 1974; Christie, 1982; DeJong and Collins, 1985; Saunders et al., 1990). Because leverage magnifies both gains and losses, more highly-leveraged firms tend to exhibit greater stock return volatility; thus, a higher operating leverage ratio and a lower capital ratio should be associated with higher risk. We also include size, measured as the market value of equity, as a control variable because increased regulatory forbearance under a too-big-to-fail policy suggests that larger banks have greater incentives to take risks than smaller banks i1. However, one can also argue that larger banks have a greater potential to diversify and reduce their asset risk.
H Barth et al. (1992) analyze federally-insured commercial banks and find that, during the 1980s, banks with assets of less than $100 million had capital ratios of 8-9%, but banks with assets of more than $10 billion had capital ratios of 4-5%.
518
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
We also include the market-to-book equity ratio, which serves as a proxy for the bank's charter value and its risk-taking incentives. Because the market-to-book equity ratio is a simple estimator of q, we classify a bank as having high (low) risk-taking incentives if its market-to-book equity ratio is less (greater) than 1.0, and we include a dummy variable that identifies if the bank has high risk-taking incentives. Finally, we include an interaction term between the market-to-book equity ratio and the dummy variable. The dummy variable and the interaction term are used to test the hypotheses concerning the time-varying relation between risk-taking behavior and risk-taking incentives. For example, according to hypothesis HI, when bank charter value and risk-control regulations are jointly effective, ex-post risk-taking behavior is limited and not significantly different for banks with high and low ex-ante risk-taking incentives. Thus, we expect the estimated /35 and /36 coefficients in Eq. (1) to be insignificantly different from zero during the pre-deregulatory regime. However, according to hypothesis H2, when charter value and regulations are jointly ineffective, ex-post risk-taking is higher for banks with lower ex-ante charter values, i.e., with higher ex-ante risk-taking incentives. Thus, we expect the estimated /35 coefficient to be significantly positive and the /36 coefficient to be significantly negative during the post-deregulatory regime.
4. Empirical results Fig. 1 plots the annual averages over the period 1977-1994 for two variables: the ex-post or year-ending standard deviation of equity returns (SDRET), which is
SDRET
MKT/BEX~K
0.08 1.8
0.07
1.6
~
0.08
1.4
0.05
1.2
0.~
. . . . . 0.6
,~'~"
0.03
~
0.02
0.4 0.01
0.2 I
0
77
I
l
78
79
]
80
I
81
J
82
I
83
i
84
~-
85
I
86
I --~----I
87
88
I
89
90
I
91
d
92
0 93
94
YEAR
I ~
MCr/t~OK--"
SDRET !
Fig. 1. Averagesby year for a sampleof 86 commercialbanks over the period 1977-1994. SDRET is the ex-postor year-endingannual standard deviation of equity returns. MKT/BOOK is the ex-ante or year-beginning market-to-bookequity ratio.
519
T.M. Galloway et al./Journal of Banking & Finance 21 (1997) 509-527
the bank risk measure; and the ex-ante or year-beginning market-to-book equity ratio ( M K T / B O O K ) , which is the proxy for charter value. Fig. 1 shows that the average value of SDRET rises from approximately 2% in 1977 to just over 6% in 1990, but falls to around 3% by 1994. Meanwhile, the average value of M K T / B O O K decreases from approximately 2.0 in 1977 to around 1.0 in the late 1980s, hits its lowest level of 0.60 in 1991, and then rebounds but is still below 1.0 in 1994. Table 2 reports descriptive statistics for SDRET and M K T / B O O K , as well as the three control variables, by regulatory regime. Panel A provides the cross-sectional averages and standard deviations, and Panel B reports the p-values for the F-tests of differences in means between regulatory regimes. Panel B indicates that the average value of the risk measure increases significantly from the pre-deregulatory to the deregulatory regime, and again from the post-deregulatory to the re-regulatory regime. It also indicates a significant decrease in the average market-to-book equity ratio from one regulatory regime to the next. Although not reported in Table 2, the proportion of sample banks with a market-to-book equity ratio less than one, and thus high risk-taking incentives, Table 2 Sample descriptive statistics by regulatory regime Regime
SDRET
MKT/BOOK OPLEV CAPITAL REALSIZE
Panel A: Descriptiue statistics
Pre-deregulatory (1977-1979)
0.02538 1.7927 (0.0089) (1.209)
0.1184 0.0590 (0.047) (0.013)
262.88 (547.8)
Deregulatory (1980-1982)
0.03449 1.5443 (0.0112) (1.202)
0.1306 0.0577 (0.046) (0.014)
224.57 (406.6)
Post-deregulatory (1983-1989)
0.03597 1.3249 (0.0147) (1.180)
0.1270 0.0585 (0.046) (0.015)
405.32 (544.9)
Re-regulatory (1990-1994)
0.04672 0.8366 (0.0310) (0.571)
0.1153 0.0636 ((I.040) (0.017)
802.90 (1080.3)
Panel B: p-calues for the F-tests of differences in means
Pre-deregulatoryvs. deregulatory
0.0001
0.0196
0.0029
0.2858
0.3675
Deregulatory vs. post-deregulatory 0.1501
0.0132
0.2820
0.4737
0.0001
Post-deregulatoryvs. re-regulatory 0.0001
0.0001
0.0001
0.0001
0.0001
Averages (and standard deviations) of several variables by regulatory regime for a sample of 86 commercial banks over the period 1977-1994. SDRET is the ex-post or year-endingannual standard deviation of equity returns. MKT/BOOK is the ex-anteor year-beginningmarket-to-bookequity ratio. OPLEV is the ex-ante ratio of book value of fixed assets to total assets. CAPITALis the ex-ante ratio of book value of equity to total assets. REALSIZE is the ex-ante real market value of shares outstanding (in millions of 1977 dollars).
520
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
rises from 21% in 1977 to 71% in 1989, and remains around 80% during the early 1990s. This rise reinforces the descriptive statistics reported for MKT/BOOK, and suggests a dramatic increase in the number of banks with high risk-taking incentives, thus making enforcement of risk-control regulations more difficult. Regarding the control variables, Table 2 shows that the average operating leverage ratio (OPLEV) and the average capital ratio (CAPITAL) remain fairly stable over time at approximately 12% and 6%, respectively. The final control variable, real market value of shares outstanding (REALSIZE), rises from an average of $263 million in the pre-deregulatory regime to an average of $803 million in the re-regulatory period. Because the mean real market value is skewed, we use the natural logarithm form of this control variable in the regression analysis. Table 3 presents the results of the OLS regression analysis using the model in Eq. (1) 12. We estimate the equation during each of the four regulatory regimes. Before examining the empirical tests of the hypotheses, we examine the coefficient estimates for the control variables. Table 3 shows that, as expected, the capital ratio has a significant negative relation with bank risk regardless of regulatory regime. Similar to Saunders et al. (1990), we find mixed results for operating leverage and bank size. The estimated operating leverage coefficient is positive in three of the four regimes, and it is the expected sign whenever significant, i.e., consistent with a positive relation between risk and leverage. The estimated size coefficient is positive and significant, as expected, in the deregulatory regime, but is significantly negative in the re-regulatory regime when restrictions were imposed on the too-big-to-fail policy. Thus, no inconsistencies are found that call into question the specification of the estimated model. We now turn to the tests of the hypotheses. According to hypothesis HI, when bank charter value and regulations are jointly effective prior to the mid-1980s, ex-post risk-taking behavior is limited and no different for banks with high and low ex-ante risk-taking incentives. Consistent with this hypothesis, the estimated r5 coefficient on the dummy variable and the estimated /36 coefficient on the interaction term are not significantly different from zero in the pre-deregulatory regime of 1977-1979. According to hypothesis H2, when charter value and regulations are jointly ineffective, ex-post risk taking is higher for banks with high ex-ante risk-taking incentives because they have more opportunities to conduct moral hazard behavior. Consistent with this hypothesis, in the post-deregulatory regime of 1983-1989, we observe a significantly positive /35 dummy variable coefficient estimate and a significantly negative /36 interaction term coefficient estimate. These results indicate that ex-post risk increased as ex-ante risk incentives increased, and that ex-post risk-taking behavior was significantly higher for high-incentives banks
12See AppendixB for the results of a sensitivityanalysis of this model.
T.M. Galloway et aL / Journal of Banking & Finance 21 (1997) 509-527
521
Table 3 Regression results SDRETjt =/30 + 131 *MKT/BOOKj.t
1 +/32 *OPLEVI.t ~ +/33 *CAPITALi.t-1 q- /34 * LNREALSIZEj,t- l +/35 * HIGHRISKj,t- 1 + /36 * HIGHRISK * MKT/BOOK), t _ 1 + ejt Regime
Independent variable
Pre-deregulatory (1977-1979)
Deregulatory (1980-1982)
Post-deregulatory (1983-1989)
Re-regulatory (1990-1994)
Intercept
0.033364 (8.67) * *
0.036734 (7.74) * "
0.045446 (10.59) * *
0.129520 (13.19) * "
MKT/BOOK
0.000359 (0.70)
0.000239 (0.37)
- 0.000450 (-0.81)
0.003694 (1.13)
OPLEV
0.010594 (0.96)
-0.(117223 ( - 1.22)
0.026944 (2.13) *
0.070191 (2.17) *
- 0.218996 (-5.21) * *
- 0.220270 (-4.65) * *
- 0.157671 (-4.02) * *
- 0.699512 (-9.49) * *
LNREALSIZE
0.000469 (1.09)
0.002424 (4.16) * *
- 0.000915 ( - 1.73)
- 0.009063 (-9.41) * *
HIGHRISK
0.004206 (0.80)
0.009223 (1.93)
0.023982 (6.56) * *
0.028895 (4.15) * *
- 0.000934 (-0.14)
- 0.008746 ( - 1.41)
- 0.027878 (-5.95) * *
- 0.037257 (-5.03) * *
CAPITAL
HIGHRISK * MKT/BOOK
Number of observations Adjusted R 2
258 0.136
258 0.199
602 0.123
36 I 0.407
OLS parameter estimates and associated t-statistics (in parentheses) using the ex-post or year-ending annual standard deviation of finn returns (SDRET) as the dependent variable. The sample consists of 86 commercial banks over the period 1977-1994. MKT/BOOK is the ex-ante or year-beginning market-to-book equity ratio. OPLEV is the ex-ante ratio of book value of fixed assets to total assets. CAPITAL is the ex-ante ratio of book value of equity to total assets. LNREALSIZE is the natural logarithm of the ex-ante real market value of shares outstanding (in millions of 1977 dollars). HIGHRISK is a dummy variable equal to one if the bank has high risk-taking incentives as indicated by an ex-ante market-to-book equity ratio less than 1.0, zero otherwise. * * p-value associated with the t-test for parameter = 0 is significant at the 0.01 level. * p-value associated with the t-test for parameter = 0 is significant at the 0.05 level.
t h a n f o r l o w - i n c e n t i v e s b a n k s . T h u s , t h e r e g r e s s i o n r e s u l t s r e p o r t e d in T a b l e 3 s u p p o r t t h e c l a i m t h a t a n i n e f f e c t i v e r i s k - c o n t r o l s y s t e m in t h e b a n k i n g i n d u s t r y b e g a n a r o u n d 1983, a n d t h a t b a n k s w i t h h i g h r i s k - t a k i n g i n c e n t i v e s a s s u m e d m o r e risk when given the opportunity, During the re-regulatory regime of 1990-1994, we find no support for hypothesis H1 t h a t c h a r t e r v a l u e a n d r i s k - c o n t r o l r e g u l a t i o n s o n c e a g a i n b e c a m e j o i n t l y e f f e c t i v e . I n s t e a d , t h e c o e f f i c i e n t e s t i m a t e s f o r the d u m m y v a r i a b l e a n d i n t e r a c t i o n
522
T.M. Galloway et al./ Journal of Banking & Finance 21 (1997) 509-527
term indicate that banks with high risk-taking incentives continued to take on significantly more bank risk than those with low risk-taking incentives, and that the new regulations did not appear to have a significant impact on risk-taking behavior.
5. Conclusions and policy implications To maintain a sound banking environment, an effective regulatory system must control both a bank's risk-taking incentives and its opportunities to take excessive risk. Traditionally, regulators have utilized two complementary risk-control devices: bank charter value and regulatory supervision. This paper documents the deterioration of the banking industry's risk-control system during the 1980s, and investigates the time-varying relation between a bank's ex-ante risk-taking incentives and its ex-post risk-taking behavior from 1977 to 1994. Using a market-tobook equity ratio to proxy for the bank's charter value and its risk-taking incentives, we test two hypotheses concerning the relation between risk incentives and risk behavior. The first hypothesis states that when the risk-control devices of charter value and regulations are jointly effective, ex-post risk-taking behavior is limited and no different for banks with high and low ex-ante risk-taking incentives, i.e., banks with low and high charter value, respectively. Such an environment existed in the U.S. banking system until the mid-1980s, when market and regulatory developments caused an increase in competition and a decrease in monitoring and foreclosure of problem banks. Consistent with this hypothesis, regression results indicate no statistical difference between the ex-post risk-taking behavior of highand low-incentives banks over the period 1977-1982. The second hypothesis states that when the risk-control devices of charter value and regulations are jointly ineffective, ex-post risk-taking behavior is higher for banks with high ex-ante risk-taking incentives than for banks with low ex-ante incentives. Consistent with this hypothesis, regression results indicate that banks with high risk-taking incentives had significantly higher risk than banks with low risk-taking incentives during the period 1983-1989. Thus, the results provide evidence that banks with high risk-taking incentives actually assumed more risk when given the opportunity. During the re-regulatory regime over 1990-1994, we find no support for the first hypothesis that charter value and risk-control regulations once again became jointly effective. Instead, regression results indicate that banks with high risk-taking incentives continued to take on significantly more risk than those with low risk-taking incentives, and that the new regulations did not appear to have a significant impact on risk-taking behavior. The percentage of problem banks and FDIC losses decreased during the re-regulatory regime. However, the average market-to-book equity ratio, a proxy
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
523
for charter value, remained below 1.0 during this regime, and the percentage of sample banks with high risk-taking incentives was highest in this regime. Thus, the reduction in problem banks during 1990-1994 can more likely be attributed to reduced interest rates, which substantially increased the profitability of banking, than to any real change in risk-taking incentives or opportunities. Our finding of increased risk-taking behavior in the 1980s and the identification of charter value as a self-imposed risk discipline factor have important regulatory implications. Because studies (John et al., 1991; Mishra and Urrutia, 1995) have found that risk-adjusted premiums alone are insufficient to eliminate excessive risk-taking behavior, our results have implications beyond the limited environment of fixed-rate premiums. First, regulatory agents should monitor banks with low charter values more frequently because they have more incentives for moral hazard behavior. Second, bank charter value should be included as a determinant for models in predicting problem banks to facilitate better recognition of problems at an early stage. Third, when regulators have insufficient resources to enforce risk-control regulations, one alternative may be to increase the charter value of the banking industry so that banks have an incentive to self-impose risk constraints. Policies that increase bank charter value include imposing tougher entry requirements and encouraging the corporate control market to discipline under-performing managers. Finally, regulators should not become complacent about the recent improvements in the banking industry. Banks with high risk-taking incentives continue to take on significantly more bank risk than those with low risk-taking incentives. The trend toward lower numbers of problem banks and FDIC losses is largely a result of lower interest rates and improved profitability, and thus, could be reversed if economic conditions change.
Acknowledgements The authors thank Warren Bailey, William Beranek, David Blackwell, Jay Brinkmann, Elizabeth Cooperman, Larry Goldberg, Andrea Heuson, VanSon Lai, Sylvia Hudgins, Charlene Sullivan, and two anonymous referees for helpful comments.
Appendix A. Sample banks 1 2 3 4 5 6
Affiliated Bankshares Colorado Inc Ameritrust Corp Amsouth Bancorp Banc One Corp Banco Popular De Puerto Rico Bancoklahoma C o o
44 45 46 47 48 49
First Virginia Banks Inc Firstar Corp New Fleet/Norstar Financial Corp Fourth Financial Corp Huntington Bancshares Inc Landmark Bancshares Corp
524 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
Bancorp Hawaii Bank of Boston Corp Bank of New England Corp Bank of New York Inc Bank South Corp BankAmerica Corp Bankers Trust NY Corp Banponce Corp Barnett Banks Inc Baybanks Inc Central Fidelity Banks Inc Central Jersey Bancorp Chase Manhattan Corp Chemical Banking Corp Citicorp City National Corp Cititrust Bancorp Colorado National Bancshares Inc Comerica Inc Commerce Bancshares Constellation Bancorp Continental Bank Corp Corestates Financial Corp Deposit Guaranty Corp Dominion Bancshares Corp Equimark Corp Fifth Third Bancorp First Alabama Bancshares Inc First American Corp TN First Bank Systems Inc First Chicago Corp First Commerce Corp New Orleans First Fidelity Bancorp NE First Florida Banks Inc First Interstate Bancorp First Security Corp DE First Tennessee National Corp
50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86
Liberty National Bancorp Inc M N C Financial Inc Manufacturers Hanover Corp Mark Twain Bancshares Inc Marshall and Ilsley Corp Mellon Bank Corp Mercantile Bancorp Inc Mercantile Bankshares Corp Merchants Bank New York NY Merchants National Corp Meridian Bancorp Inc Michigan National Corp Morgan J P and Co Inc NCNB Corp N B DBancorp National City Corp Northern Trust Corp Norwest Corp P N C Financial Corp Republic New York Corp Riggs National Corp Wash DC Santa Monica Bank Security Pacific Corp Shawmut National Corp Signet Banking Corp Society Corp South Carolina National Corp Southeast Banking Corp Southern National Corp State Street Boston Corp U J B Financial Corp Union Planters Corp United Banks Colorado Inc United States Bancorp OR Valley National Corp AZ Wells Fargo and Co Westamerica Bancorp
Appendix B. Sensitivity analysis A l t e r n a t i v e b a n k risk p r o x y . We estimate Eq. (1) using the loan-to-deposit ratio, an accounting-based risk measure, as the dependent variable. The regression
T.M. Gallowayet al./ Journal of Banking & Finance21 (1997) 509-527
525
results are similar to those reported in Table 3, except the coefficient estimates for the market-to-book ratio are significantly negative in the first three regulatory regimes. Alternative charter value proay. We estimate Eq. (1) using the market-to-book asset ratio as a proxy for charter value. This alternative proxy has a correlation of 0.67 with the market-to-book equity ratio. The regression results are very similar to those reported in Table 3, except the coefficient estimates for the market-to-book ratio are significantly positive during the pre-deregulatory and deregulatory periods. Alternative leverage measures. We calculate alternative operating and financial leverage measures based on market value of equity instead of book value of equity. The correlations between the original and alternative values are 0.94 for the operating leverage ratio and 0.38 for the capital ratio. The regression results using the alternative leverage measures are qualitatively similar to those reported in Table 3, except the coefficient estimates for the alternative capital ratio are now positive and insignificant in the first three regulatory regimes. State of incorporation. When we add state of incorporation as an independent variable in Eq. (1), the coefficient estimate of the variable is significant in only the pre-deregulatory and deregulatory regimes, which is consistent with the relaxation of interstate banking restrictions and the trend toward national competition that began in the early 1980s. However, the coefficient estimates of the original variables are very similar to those in Table 3. Too-big-to-fail banks. We designate l 1 banks as too-big-to-fail (TBTF) based on a list published in the Wall Street Journal after the Comptroller of the Currency acknowledged the TBTF policy in testimony before Congress in September 1984. (See O'Hara and Shaw (1990), table V.) The median value of total assets for these 11 banks for 1977-1994 is $55.9 billion compared to $4.4 billion for the remaining 75 banks in the sample. When we estimate Eq. (1) excluding the 11 TBTF banks, there is no substantive effect on the results. Non-bank homing companies. The final sample includes both banks and BHCs. For the BHCs, the balance sheet information obtained from S&P Stock Reports represents the BHC's primary banks. Further, the assets reported do not include anything that is unrelated to normal banking operations. When we exclude the six firms that are not clearly identified by S&P as BHCs and estimate Eq. (1), the regression results are not substantially affected. Risk-based premium structure. It is possible that the change from fixed-rate to risk-based pricing in January 1993 could affect the regression results in the re-regulatory regime. When we limit the re-regulatory regime to 1990-1992 rather than 1990-1994, the basic regression results are unchanged. Confounding effect of deposit insurance subsidy. It is possible that inferences made using the market-to-book equity ratio are suspect due to a confounding effect of the deposit insurance subsidy in the numerator of the ratio. This problem could cause us to pool banks that have high charter values with those that have
526
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
large insurance subsidies. W e identify banks that are more likely to receive a high subsidy as those banks with a market-to-book ratio greater than 1.0, a capital ratio less than 3%, and an equity return variance in the top 25% of the sample. The search yields only three out of 1548 observations in this "insurance subsidy" group. Thus, we conclude that our inferences using the market-to-book ratio are not suspect due to the confounding effect of the insurance subsidy. Multicollinearity. Multicollinearity does not appear to be a severe problem. The strongest pairwise correlation among the independent variables is - 0 . 1 6 for the market-to-book ratio and the size measure. Further, following the procedure of Belsey, Kuh, and Welsch, we examine the four condition numbers from the regressions in Table 3 and find that none exceeds 24. Finally, the variance inflation factors for the four main independent variables in the regressions are less than 1.15 in nearly all cases. Heteroscedasticity. W e use the White specification test to examine whether the regression errors are not independent or not constant. For the four regressions in Table 3, the White chi-square test of first- and second-moment specification shows that the null hypothesis of no misspecification is rejected in only one case (with p-value of 0.0431). For this case, we use W h i t e ' s heteroscedasticity-consistent variance-covariance matrix to calculate adjusted t-statistics, and we find no substantive change from the original results. Autocorrelation. W e use the D u r b i n - W a t s o n d-statistic to examine whether the regression errors exhibit first-order autocorrelation. When we estimate Eq. (1) for each bank over 1977-1994, we do not reject the null hypothesis of zero autocorrelation for 45% of the banks, and the test is inconclusive for the remaining 55% (at the 5% significance level).
References Barth, J.R., R.D. Brumbaugh, Jr. and R.E. Litan, 1992, The future of American banking (M.E. Sharpe, Inc., Armonk, NY). Brickley, J.A. and C.M. James, 1986, Access to deposit insurance, insolvency rules and the stock returns of financial institutions, Journal of Financial Economics 16, 345-371. Buser, S.A., A.H. Chen and E.J. Kane, 1981, Federal deposit insurance, regulatory policy, and optimal bank capital, Journal of Finance 36, 51-60. Christie, A.A., 1982, The stochastic behavior of common stock variances: Value, leverage and interest rate effects, Journal of Financial Economics 10, 407-432. Chung, K.H. and S.W. Pruitt, 1994, A simple approximation of Tobin's q, Financial Management 23, 70-74. Collins, M.C., D.W. Blackwell and J.F. Sinkey, Jr., 1994, Financial innovation, investment opportunities, and corporate policy choices for large bank holding companies, Financial Review 29, 223 -247. Crawford, A.J., J.R. Ezzell and J.A. Miles, 1994, Bank CEO pay-performance relations and the effects of deregulation, Unpublished working paper (Penn State University). DeJong, D.V. and D.W. Collins, 1985, Explanations for the instability of equity beta: Risk-free rate changes and leverage effects, Journal of Financial and Quantitative Analysis 20, 73-94.
T.M. Galloway et al. /Journal of Banking & Finance 21 (1997) 509-527
527
Galai, D. and R.W. Masulis, 1976, The option pricing model and the risk factor of stock, Journal of Financial Economics 3, 53-81. Gaver, J.J. and K.M. Gaver, 1993, Additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies, Journal of Accounting and Economics 16, 125-160. Gaver, J.J. and K.M. Gaver, 1995, Compensation policy and the investment opportunity set, Financial Management 24, 19-32. Hamada, R.S., 1972, The effect of the firm's capital structure on the systematic risk of common stocks, Journal of Finance 27, 435-452. John, K., T.A. John and L.W. Senbet, 1991, Risk-shifting incentives of depository institutions: A new perspective on federal deposit insurance reform, Journal of Banking and Finance 15, 895-915. Kane, E.J. and H. Unal, 1988, Change in market assessments of deposit institution riskiness, Journal of Financial Services Research 1, 207-229. Kane, E.J. and H. Unal, 1990, Modeling structural and temporal variation in the market's valuation of banking firms, Journal of Finance 45, 113-136. Kaufman, G.G., 1994, The current state of banking reform, Research in Financial Services 6, 281-312. Keeley, M.C., 1990, Deposit insurance, risk, and market power in banking, American Economic Review 80, 1183-1200. Lev, B., 1974, On the association between operating leverage and risk, Journal of Financial and Quantitative Analysis 9, 627-641. Lindenberg, E.B. and S.A. Ross, 1981, Tobin's q ratio and industrial organization, Journal of Business 54, 1-32. Marcus, A.J., 1984, Deregulation and bank financial policy, Journal of Banking and Finance 8, 557-565. Merton, R.C., 1977, An analytic derivation of the cost of deposit insurance and loan guarantees, Journal of Banking and Finance 1, 3-11. Mishra, C. and J.L. Urrutia, 1995, Deposit insurance subsidies, moral hazard, and bank regulation, Journal of Economics and Finance 19, 63-74. O'Hara, M. and W. Shaw, 1990, Deposit insurance and wealth effects: The value of being "too big to fail", Journal of Finance 45, 1587-1600. Perfect, S.B. and K.W. Wiles, 1994, Alternative constructions of Tobin's q: An empirical comparison, Journal of Empirical Finance 1, No. 3/4. Saunders, A., E. Strock and N.G. Travlos, 1990, Ownership structure, deregulation, and bank risk taking, Journal of Finance 45, 643-654.
Journal of Banking & Finance 21 (1997) 509-527
BANKING & FINANCE
Banks' changing incentives and opportunities for risk taking Tina M. Galloway a,*, Winson B. Lee b, Dianne M. Roden c a Unit,ersity of Miami, Coral Gables, FL 33124, USA b Universi~' tff'Colorado at Denver, Denver, CO 80217, USA c Indiana Unit,ersi~, at Kokomo, Kokomo, IN 46904, USA
Received 29 September 1995; accepted 20 September 1996
Abstract This paper investigates the deterioration of the banking industry's risk-control system during the 1980s and the time-varying relation between a bank's ex-ante risk-taking incentives and its ex-post risk-taking behavior over the period 1977-1994. We document that banks with high charter value imposed self-discipline on risk-taking behavior at all times. In contrast, banks with low charter value assumed significantly more risk beginning around 1983, and this behavior continued into the early 1990s. These findings have several important policy implications. JEL classification." G21 ; G28 Keywords: Risk taking; Charter value; Regulation
1. Introduction
Since the late 1970s, the banking industry has undergone dramatic change, switching first from a regulated environment to broad deregulation in the early
* Corresponding author. University of Miami, Department of Finance, P.O. Box 248094, Coral Gables, FL 33124-6552; (305) 284-1883; Fax (305) 284-4800; Intemet: [email protected] 0378-4266/97/$17.00 Copyright © 1997 Elsevier Science B.V. All rights reserved. PHS0378-4266(96)00052-0
510
T.M. Galloway et aL / Journal of Banking & Finance 21 (1997) 509-527
1980s, and then back toward a regulated environment in the early 1990s 1. To maintain a sound and stable banking environment, an effective regulatory system must control not only the bank's incentives but also its opportunities to take excessive risk. Much of the current regulatory structure was developed on an ad hoc basis in response to developments and crises as they occurred. This paper investigates the deterioration of the banking industry's risk-control system during the 1980s and the time-varying relation between a bank's ex-ante risk-taking incentives and its ex-post risk-taking behavior over the period 1977-1994. A fixed-rate deposit insurance premium was in place until the FDICIA mandated a change to risk-adjusted premiums effective January 1993. Merton (1977) formulates fixed-rate deposit insurance as a put option that gives wealth-maximizing banks an incentive to increase risk to obtain a larger insurance subsidy. Under such a policy, banks are not penalized for risk-taking behavior; instead, they can issue insured deposits near the risk-free rate to finance risky ventures and are allowed to keep most of the upward potential from the investment while transferring most of the downside risk to the Federal Deposit Insurance Corporation (FDIC). To control risk-taking behavior, regulators have utilized two traditional risk-control devices: bank charter value and regulatory supervision. Bank charter value, i.e., the value of the right to continue to operate, is created through regulatory restrictions on entry and competition and is identified as a bank's self-imposed risk-discipline device (Buser et al., 1981; Marcus, 1984; Keeley, 1990). A bank with a high charter value has an incentive to avoid a high-risk strategy, because the owners of the bank cannot sell the charter if the bank is declared insolvent. In line with this argument, Keeley (1990) finds that banks with higher charter value follow a lower-risk strategy by holding more capital relative to assets. However, charter value alone does not eliminate the agency problem between the FDIC and banks. If charter value decreases due to bank-specific or industrywide events, the potential loss of charter value may no longer function as a risk-taking disincentive. In this case, following a higher-risk strategy, either by decreasing capital relative to assets or by increasing asset risk, may produce an expected gain in the value of the bank's deposit insurance subsidy that is larger than the expected loss of its charter value (Keeley, 1990). To mitigate the shortcoming of charter value as a risk-control device, the FDIC and other bank regulators impose risk-control regulations to further restrict the risk level in the banking industry. These agencies regulate banks through periodic
l Deregulatory legislation includes the Depository Institutions Deregulation Monetary Control Act (DIDMCA) of 1980 and the Garn-St. Germain Depository Institutions Act of 1982. Re-regulatory legislation includes the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 and the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991.
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
511
monitoring and timely foreclosure of insolvent banks. In January 1993, the FDIC began using a risk-based premium structure that assesses varying premiums across nine risk categories. Some critics argued, however, that the spread in premiums between the safest and riskiest banks was insufficient to seriously dissuade risky banks from conducting moral hazard behavior (Kaufman, 1994) 2. On balance, the two risk-control devices of charter value and regulations are complementary. Operating under risk-control regulations, banks with low charter value have some risk-taking incentives, but have limited opportunities to conduct moral hazard behavior. Meanwhile, the remaining banks with high charter value and limited risk-taking incentives operate in a self-control mode, allowing regulators to concentrate their limited resources on the small group of high-risk banks. Before the mid-1980s, charter value and regulations were jointly successful in restricting banks' opportunistic behavior, as illustrated by the small number of bank failures in the FDIC's early history 3 After this time, however, the effectiveness of these risk-control devices was seriously impaired. Due to increased competition resulting from deregulation, technological advances, and financial innovations in the banking industry beginning in the early 1980s, bank charter values fell significantly and banks operated with a lower degree of regulatory protection. Further, the enforcement of monitoring and foreclosure of problem banks was relaxed when the FDIC was decapitalized at the same time as the number of problem banks increased. We hypothesize that these market and regulatory developments gave banks increased risk-taking incentives and opportunities beginning in the mid-1980s, and that banks with higher incentives assumed more risk when given the opportunity. We also investigate whether the re-regulatory environment of the early 1990s helped to control risk-taking behavior. Using a sample of 86 commercial banks over 1977-1994, we examine the time-varying relation between the banks' ex-ante risk-taking incentives and their ex-post risk-taking behavior 4. We find
2 In January 1993, premiums per $100 of insured deposits ranged from 23¢ for well-capitalized, healthy banks to 31¢ for under-capitalized banks with substantial supervisory problems. In January 1996, the premiums were reduced and now range from nearly zero to a maximum of 27¢ per $1(10 of insured deposits. 3 For example, according to FDIC Annual Reports, 1143 banks failed during the period 1983-199(I, more than five times the number (228) of bank failures that occurred during the previous 38 years (1945-1982). a Keeley (1990) finds a contemporaneous positive relation between charter value and bank capital, and thus a negative relation between charter value and risk. However, a contemporaneous relation may simply reflect a bank's superior performance and not necessarily its intentions to take on less risk (see Galai and Masulis, 19761. Thus, we examine the relation between the bank's ex-ante risk-taking incentives and ex-post risk-taking behavior. Further, Keeley implicitly assumes the relation between charter value and risk-taking is constant over time. Given the changing effectiveness of regulation over time, we also test the time-varying relation between ex-ante risk-taking incentives and ex-post behavior.
512
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
that the average market-to-book equity ratio, a proxy for charter value, fell significantly during the period analyzed. Banks with low ex-ante charter value increased ex-post risk significantly beginning in the mid-1980s. In contrast, banks with high ex-ante charter value maintained a low-risk strategy at all times. We also find that banks with low charter value continued to take on more risk than banks with high charter value after regulations were tightened in the early 1990s. These findings further the understanding of the conditions that trigger bank risk-taking behavior, and are useful for deposit insurance and regulatory policy reform. The paper is organized as follows. In the next section, we discuss bank charter value and the enforcement of risk-control regulations. We then develop hypotheses concerning banks' changing incentives for risk taking. In Section 3, we describe the sample and empirical methods used to test the hypotheses. In Section 4, we present the empirical results. Finally, in Section 5 we present the conclusions and policy implications.
2. Predictions for bank risk-taking behavior 2. l. Bank charter value
Bank charter value is the expected amount of future profits arising from entry barriers and branching restrictions that limit competition. Collins et al. (1994) state that the charter represents the ultimate unbooked growth option because it permits the bank to operate. Because the charter value is realized only if the bank survives, Marcus (1984) advocates that bank charter value affects risk-taking incentives. Hence, a bank with a high charter value is less likely to take excessive risk that jeopardizes its survival and, thus, its stream of future cash flows. Because charter value is an intangible asset that represents a bank's growth opportunities, Tobin's q, defined as the ratio of the market value of a firm to the replacement cost of its assets, is an attractive theoretical measure to capture charter value. Lindenberg and Ross (1981) propose a complex estimator of q to measure monopoly rent in non-banking industries. However, Chung and Pruitt (1994) and Perfect and Wiles (1994) find that empirically simpler estimators are highly correlated with the Lindenberg and Ross estimator. Thus, we use a simple estimator of q, the market-to-book equity ratio, as a proxy for charter value 5 Because a bank's assets include assets-in-place and unbooked assets such as the charter value, the numerator of the market-to-book equity ratio should reflect the
5 Keeley (1990) uses a market-to-book asset ratio as a proxy for charter value. Collins et al. (1994) use a market-to-book equity ratio as a proxy for growth opportunities, while G a v e r and G a v e r (1993, 1995) use both a market-to-book equity and a market-to-book asset ratio (correlation - 0.47).
T.M. Galloway et al./Journal of Banking & Finance 21 (1997) 509-527
513
capitalized value of the bank charter, and the denominator should not. Thus, the higher the charter value, the higher the market-to-book equity ratio 6 We expect to observe a decrease in charter value beginning in the mid-1980s because of increased competition resulting from market and regulatory developments. For example, deregulation in the early 1980s allowed thrifts and credit unions to offer similar products and compete directly for the same customers. Further, technological advances, such as the automatic teller machine and telephone banking, and the erosion of interstate banking expansion restrictions moved the competition toward a national level. Finally, innovations such as money market mutual funds caused banks to lose deposits, while junk bonds and the opening of global markets provided loan customers with new financing alternatives. Due to the move back toward a regulated environment that began with FIRREA in 1989, we might expect bank charter values to increase and risk-taking incentives to decrease in the early 1990s. However, many of the market forces keeping competition at a high level were still in place, and the spread of only 8¢ in risk-adjusted premiums may have been insufficient to dissuade risky banks from conducting moral hazard behavior.
2.2. The enforcement of risk-control regulations Regulators minimize bank risk-taking opportunities by imposing regulations such as risk-based monitoring and timely foreclosure of insolvent banks. A new bank must satisfy minimum capital requirements in order to be granted a charter and deposit insurance. The FDIC strives to closely monitor the amount of capital. Given the limited resources of the FDIC, regulations are most effectively enforced if the total number of problem banks is small. Conditional on Marcus' (1984) prediction, the enforcement of risk-control regulations is most effective if the average bank charter value is relatively high. Given the market and regulatory developments of the early 1980s, a decrease in charter value and thus an increase in the number of problem banks in the mid-1980s is expected. Thus, we expect a contemporaneous weakening of the FDIC's financial strength and its ability to enforce risk-control regulations. However, some strengthening is expected to occur in the 1990s given the move back toward a regulated environment. FIRREA (1989) was enacted to reform, recapitalize, and consolidate the federal deposit
6 One difficulty in using the market-to-book equity ratio to proxy for charter value is that the numerator may reflect the capitalized value of not only charter value but also other sources of unbooked capital. Kane and Unal (1990) develop a model to estimate two sources of a bank's hidden capital: unbookable off-balance-sheet items and misvaluation of bookable on-balance-sheet items. Applying Kane and Unal's procedure to our sample of banks, we find that unbooked items, such as charter value, contribute more to the market value of equity than does undervaluation of on-balance-sheet items.
514
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
Table 1 Descriptive statistics for the FDIC's financial condition
Year
Problem banks to insured banks (%)
On-site exams to insured banks (%)
Problem bank assets to insured bank assets (%)
FDIC losses to insured bank assets (%)
Ratio of Bank Insurance Fund to total insured deposits
1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
2.6 2.4 2.0 1.5 1.5 2.6 4.4 5.8 7.9 10.5 11.5 10.7 8.7 8.5 9. l 7.5 4.3 2.5
48.3 51.9 50.2 45.5 N/A 38.9 N/A 23.1 20.4 22.5 26.7 30.5 29.2 33.1 36.9 42.0 47.1 41.4
N/A N/A N/A N/A N/A N/A N/A 9.1 8.7 11.4 12.0 11.2 7.2 12.1 17.8 13.2 7.3 1.0
0.0002 0.0006 0.0006 0.0017 0.0383 0.0523 0.0609 0.0596 0.0369 0.0586 0.0674 0.2195 0.1856 0.0830 0.1827 0.1130 0.0158 0.0035
1.15 1.16 1.21 1.16 1.24 1.21 1.22 1.19 1.19 1.12 1.10 0.80 0.70 0.21 (0.36) (0.01) 0.69 1.15
Source: FDIC Annual Reports and the Statistical Abstract of the United States. N / A = not available.
insurance system. The legislation resulted in the higher standards and improved reporting. FDICIA (1991) required early structured intervention and resolution by regulators, and introduced risk-based insurance premiums. Table 1 reports descriptive statistics for the FDIC's condition over the period 1977-1994. As Table 1 shows, the ratio of problem banks to insured banks rises from 3% in 1977 to around 11% in the late 1980s, but falls back to 3% by 1994. The ratio of problem bank assets to insured banks assets exhibits a similar pattern over time. As for costs of resolution, the ratio of FDIC losses to insured bank assets increases from 0.0002% in 1977 to around 0.2% in the late 1980s, and decreases to 0.0035% in 1994. Meanwhile, the ratio of the Bank Insurance Fund (BIF) to total insured deposits falls from approximately 1.2 in the late 1970s to 0.2 in 1990, but rises to 1.2 by 1994. The ratio of on-site audits to insured banks exhibits a similar pattern over time 7. Thus, the data in Table 1 suggest first a weakening of the monitoring
7 The advancement of computer technology, the expanded amount of bank-specific information reported to the FDIC, and the improved accuracy of bank prediction models may have increased the power of off-site monitoring, thus reducing the frequency of on-site monitoring necessary to achieve the same degree of control.
T.M. Gallowayet al. / Journal of Banking & Finance 21 (1997) 509-527
515
system and an increase in the ability of banks to conduct moral hazard behavior without detection during the 1980s, and then some reversal of this weakening in the early 1990s. 2.3. Hypothesis development
We now offer two hypotheses regarding bank risk-taking incentives and behavior under different regulatory regimes characterized by varying degrees of effectiveness of the risk-control devices of charter value and regulations. First, when these risk-control devices are jointly effective, i.e., average bank charter value is relatively high and the FDIC is equipped with solid financial resources, banks with high charter value, in fear of losing future cash flows, have no incentives to assume more risk. Further, the small number of banks with low charter value and high risk-taking incentives have no opportunities to assume more risk because the FDIC intensely monitors them, and forecloses them when necessary. In particular, we hypothesize: HI: When bank charter value and risk-control regulations are jointly effective, ex-post risk-taking behavior is limited and no different for banks with high and low ex-ante risk-taking incentives. Second, due to increased competition resulting from market and regulatory developments, average charter value for banks is expected to decrease significantly beginning in the mid-1980s. Such a reduction in charter value reduces banks' self-control and increases their risk-taking incentives. Given a contemporaneous financial weakening of the FDIC, regulators are unable to perform their monitoring and foreclosure roles effectively. Hence, banks with low charter value and high risk-taking incentives have expanded opportunities to assume more risk. However, banks with high charter value and low risk-taking incentives continue to maintain a low-risk profile. Thus, we hypothesize: H2: When bank charter value and risk-control regulations are jointly ineffective, ex-post risk-taking behavior is higher for banks with high ex-ante risk-taking incentives than for banks with low ex-ante risk-taking incentives. Finally, due to the move back toward regulation in the early 1990s, we expect a strengthening of regulators' abilities to perform monitoring and foreclosure. We also expect charter values to increase. If charter values rise sufficiently and risk-control regulations are strengthened sufficiently, then we expect to find support for hypothesis H1 during the 1990s. However, if the improvement in charter values and the regulatory system are insufficient, we expect to find support for hypothesis H2 during the 1990s.
516
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
3. The sample and empirical methods The sample includes commercial banks and bank holding companies. Data are collected for each bank from the daily CRSP database and from S&P Stock Reports over the period 1977-1994 8. Appendix A contains the names of the 86 banks in the final sample. Although the sample size is small compared to the population of banks and bank holding companies, the total assets of the sample banks account for 45-55% of the total assets of the approximately 14,000 federally-insured commercial banks during the sample period.
3.1. Regulatory regimes We divide the sample period of 1977-1994 into four regulatory regimes characterized by varying degrees of effectiveness of the risk-control devices of charter value and regulations. The pre-deregulatory regime includes 1977-1979, the deregulatory regime covers 1980-1982, the post-deregulatory regime covers 1983-1989, and the re-regulatory regime includes 1990-1994 9. We designate 1980-1982 as the deregulatory regime due to several significant events affecting bank activity and interest rates. For example, in late 1979, the Federal Reserve changed its monetary policy operating targets, resulting in increased volatility in interest rates. Further, Congress passed two major deregulation bills: DIDMCA in 1980 and the Garn-St. Germain Depository Institutions Act in 1982. The early 1980s also saw the beginning of the erosion of intrastate and interstate banking restrictions. We designate 1990-1994 as the re-regulatory regime due to the passage of FIRREA in August 1989 and FDICIA in late 1991 J0
8 It is possible the sample contains a survival bias. However, assuming most of the banks excluded from the sample have low charter value and high risk, this exclusion would bias the analysis against finding a significant relation. Hence, the sample restriction actually provides a more stringent test of our hypotheses. 9 Brickley and James (1986) separate the period 1976-1979 from 1980-1982 in their study of changing insolvency rules. Kane and Unal (1988) study the variability of financial institution risk over 1975-1985, and find switch points in 1977, 1979, and 1982. Saunders et al. (1990) study bank ownership and risk taking, and define three regimes: 1978, 1979-1982, and 1983-1985. Collins et al. (1994) investigate banks' investment opportunities and corporate policy choices, and define pre- and post-deregulatory periods of 1977-1979 and 1983-1985. Finally, Crawford et al. (1994) compare CEO pay and bank performance during a 1976-1981 regulation period and a 1982-1988 deregulation period. l0 We use the dummy variable method of structuring a Chow test to confirm that the four regulatory regimes have different slope and intercept coefficients in our model relating risk-taking behavior to risk-taking incentives. We use a general test of linear restrictions to test the null hypothesis that the coefficients are the same between each pair of regimes. In each case, the null hypothesis of equal coefficients is rejected at the 0.01 significance level.
T.M, Galloway et al./ Journal of Banking & Finance 21 (1997) 509-527
517
3.2. Empirical model We estimate the following ordinary least squares (OLS) regression model to test for a relation between ex-post risk-taking behavior and ex-ante risk-taking incentives: SDRETj, = 130 +/31 *MKT/BOOKj,,_~ +/32 *OPLEVj. , +/33 * CAPITALj,t-i +/34 * LNREALSIZEj,,_ 1 +/35 * HIGHRISKi,t i
+/36 * H I G H R I S K * M K T / B O O K j . t - 1
+ Ejt
(1)
where, for bank j, SDRET is the ex-post (year t) annual standard deviation of weekly equity returns; M K T / B O O K is the ex-ante (year t - 1) market-to-book equity ratio; OPLEV is the ex-ante operating leverage; CAPITAL is the ex-ante equity capitalization ratio; LNREALSIZE is the natural logarithm of the ex-ante real market value of shares outstanding (in millions of 1977 dollars); HIGHRISK is a dummy variable equal to one if the bank has high risk-taking incentives as indicated by an ex-ante market-to-book equity ratio less than one, zero otherwise; and ~ is a random error term for year t. The variables in Eq. (l) are discussed below.
3.3. Dependent and independent variables Similar to Saunders et al. (1990), who investigate the relation between bank risk taking and bank ownership structure, we emphasize a capital market assessment of bank risk. Specifically, we use the annual standard deviation of the bank' s weekly equity returns (SDRET) as our measure of bank risk. We also use the same control variables as Saunders et al. (1990), namely, operating leverage, equity capitalization, and size. We use the ratio of book value of fixed assets to total assets as a proxy for operating leverage, and the ratio of book value of equity to total assets as a proxy for capitalization or financial leverage. These two variables are expected to be, respectively, positively and negatively related to risk (Hamada, 1972; Lev, 1974; Christie, 1982; DeJong and Collins, 1985; Saunders et al., 1990). Because leverage magnifies both gains and losses, more highly-leveraged firms tend to exhibit greater stock return volatility; thus, a higher operating leverage ratio and a lower capital ratio should be associated with higher risk. We also include size, measured as the market value of equity, as a control variable because increased regulatory forbearance under a too-big-to-fail policy suggests that larger banks have greater incentives to take risks than smaller banks i1. However, one can also argue that larger banks have a greater potential to diversify and reduce their asset risk.
H Barth et al. (1992) analyze federally-insured commercial banks and find that, during the 1980s, banks with assets of less than $100 million had capital ratios of 8-9%, but banks with assets of more than $10 billion had capital ratios of 4-5%.
518
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
We also include the market-to-book equity ratio, which serves as a proxy for the bank's charter value and its risk-taking incentives. Because the market-to-book equity ratio is a simple estimator of q, we classify a bank as having high (low) risk-taking incentives if its market-to-book equity ratio is less (greater) than 1.0, and we include a dummy variable that identifies if the bank has high risk-taking incentives. Finally, we include an interaction term between the market-to-book equity ratio and the dummy variable. The dummy variable and the interaction term are used to test the hypotheses concerning the time-varying relation between risk-taking behavior and risk-taking incentives. For example, according to hypothesis HI, when bank charter value and risk-control regulations are jointly effective, ex-post risk-taking behavior is limited and not significantly different for banks with high and low ex-ante risk-taking incentives. Thus, we expect the estimated /35 and /36 coefficients in Eq. (1) to be insignificantly different from zero during the pre-deregulatory regime. However, according to hypothesis H2, when charter value and regulations are jointly ineffective, ex-post risk-taking is higher for banks with lower ex-ante charter values, i.e., with higher ex-ante risk-taking incentives. Thus, we expect the estimated /35 coefficient to be significantly positive and the /36 coefficient to be significantly negative during the post-deregulatory regime.
4. Empirical results Fig. 1 plots the annual averages over the period 1977-1994 for two variables: the ex-post or year-ending standard deviation of equity returns (SDRET), which is
SDRET
MKT/BEX~K
0.08 1.8
0.07
1.6
~
0.08
1.4
0.05
1.2
0.~
. . . . . 0.6
,~'~"
0.03
~
0.02
0.4 0.01
0.2 I
0
77
I
l
78
79
]
80
I
81
J
82
I
83
i
84
~-
85
I
86
I --~----I
87
88
I
89
90
I
91
d
92
0 93
94
YEAR
I ~
MCr/t~OK--"
SDRET !
Fig. 1. Averagesby year for a sampleof 86 commercialbanks over the period 1977-1994. SDRET is the ex-postor year-endingannual standard deviation of equity returns. MKT/BOOK is the ex-ante or year-beginning market-to-bookequity ratio.
519
T.M. Galloway et al./Journal of Banking & Finance 21 (1997) 509-527
the bank risk measure; and the ex-ante or year-beginning market-to-book equity ratio ( M K T / B O O K ) , which is the proxy for charter value. Fig. 1 shows that the average value of SDRET rises from approximately 2% in 1977 to just over 6% in 1990, but falls to around 3% by 1994. Meanwhile, the average value of M K T / B O O K decreases from approximately 2.0 in 1977 to around 1.0 in the late 1980s, hits its lowest level of 0.60 in 1991, and then rebounds but is still below 1.0 in 1994. Table 2 reports descriptive statistics for SDRET and M K T / B O O K , as well as the three control variables, by regulatory regime. Panel A provides the cross-sectional averages and standard deviations, and Panel B reports the p-values for the F-tests of differences in means between regulatory regimes. Panel B indicates that the average value of the risk measure increases significantly from the pre-deregulatory to the deregulatory regime, and again from the post-deregulatory to the re-regulatory regime. It also indicates a significant decrease in the average market-to-book equity ratio from one regulatory regime to the next. Although not reported in Table 2, the proportion of sample banks with a market-to-book equity ratio less than one, and thus high risk-taking incentives, Table 2 Sample descriptive statistics by regulatory regime Regime
SDRET
MKT/BOOK OPLEV CAPITAL REALSIZE
Panel A: Descriptiue statistics
Pre-deregulatory (1977-1979)
0.02538 1.7927 (0.0089) (1.209)
0.1184 0.0590 (0.047) (0.013)
262.88 (547.8)
Deregulatory (1980-1982)
0.03449 1.5443 (0.0112) (1.202)
0.1306 0.0577 (0.046) (0.014)
224.57 (406.6)
Post-deregulatory (1983-1989)
0.03597 1.3249 (0.0147) (1.180)
0.1270 0.0585 (0.046) (0.015)
405.32 (544.9)
Re-regulatory (1990-1994)
0.04672 0.8366 (0.0310) (0.571)
0.1153 0.0636 ((I.040) (0.017)
802.90 (1080.3)
Panel B: p-calues for the F-tests of differences in means
Pre-deregulatoryvs. deregulatory
0.0001
0.0196
0.0029
0.2858
0.3675
Deregulatory vs. post-deregulatory 0.1501
0.0132
0.2820
0.4737
0.0001
Post-deregulatoryvs. re-regulatory 0.0001
0.0001
0.0001
0.0001
0.0001
Averages (and standard deviations) of several variables by regulatory regime for a sample of 86 commercial banks over the period 1977-1994. SDRET is the ex-post or year-endingannual standard deviation of equity returns. MKT/BOOK is the ex-anteor year-beginningmarket-to-bookequity ratio. OPLEV is the ex-ante ratio of book value of fixed assets to total assets. CAPITALis the ex-ante ratio of book value of equity to total assets. REALSIZE is the ex-ante real market value of shares outstanding (in millions of 1977 dollars).
520
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
rises from 21% in 1977 to 71% in 1989, and remains around 80% during the early 1990s. This rise reinforces the descriptive statistics reported for MKT/BOOK, and suggests a dramatic increase in the number of banks with high risk-taking incentives, thus making enforcement of risk-control regulations more difficult. Regarding the control variables, Table 2 shows that the average operating leverage ratio (OPLEV) and the average capital ratio (CAPITAL) remain fairly stable over time at approximately 12% and 6%, respectively. The final control variable, real market value of shares outstanding (REALSIZE), rises from an average of $263 million in the pre-deregulatory regime to an average of $803 million in the re-regulatory period. Because the mean real market value is skewed, we use the natural logarithm form of this control variable in the regression analysis. Table 3 presents the results of the OLS regression analysis using the model in Eq. (1) 12. We estimate the equation during each of the four regulatory regimes. Before examining the empirical tests of the hypotheses, we examine the coefficient estimates for the control variables. Table 3 shows that, as expected, the capital ratio has a significant negative relation with bank risk regardless of regulatory regime. Similar to Saunders et al. (1990), we find mixed results for operating leverage and bank size. The estimated operating leverage coefficient is positive in three of the four regimes, and it is the expected sign whenever significant, i.e., consistent with a positive relation between risk and leverage. The estimated size coefficient is positive and significant, as expected, in the deregulatory regime, but is significantly negative in the re-regulatory regime when restrictions were imposed on the too-big-to-fail policy. Thus, no inconsistencies are found that call into question the specification of the estimated model. We now turn to the tests of the hypotheses. According to hypothesis HI, when bank charter value and regulations are jointly effective prior to the mid-1980s, ex-post risk-taking behavior is limited and no different for banks with high and low ex-ante risk-taking incentives. Consistent with this hypothesis, the estimated r5 coefficient on the dummy variable and the estimated /36 coefficient on the interaction term are not significantly different from zero in the pre-deregulatory regime of 1977-1979. According to hypothesis H2, when charter value and regulations are jointly ineffective, ex-post risk taking is higher for banks with high ex-ante risk-taking incentives because they have more opportunities to conduct moral hazard behavior. Consistent with this hypothesis, in the post-deregulatory regime of 1983-1989, we observe a significantly positive /35 dummy variable coefficient estimate and a significantly negative /36 interaction term coefficient estimate. These results indicate that ex-post risk increased as ex-ante risk incentives increased, and that ex-post risk-taking behavior was significantly higher for high-incentives banks
12See AppendixB for the results of a sensitivityanalysis of this model.
T.M. Galloway et aL / Journal of Banking & Finance 21 (1997) 509-527
521
Table 3 Regression results SDRETjt =/30 + 131 *MKT/BOOKj.t
1 +/32 *OPLEVI.t ~ +/33 *CAPITALi.t-1 q- /34 * LNREALSIZEj,t- l +/35 * HIGHRISKj,t- 1 + /36 * HIGHRISK * MKT/BOOK), t _ 1 + ejt Regime
Independent variable
Pre-deregulatory (1977-1979)
Deregulatory (1980-1982)
Post-deregulatory (1983-1989)
Re-regulatory (1990-1994)
Intercept
0.033364 (8.67) * *
0.036734 (7.74) * "
0.045446 (10.59) * *
0.129520 (13.19) * "
MKT/BOOK
0.000359 (0.70)
0.000239 (0.37)
- 0.000450 (-0.81)
0.003694 (1.13)
OPLEV
0.010594 (0.96)
-0.(117223 ( - 1.22)
0.026944 (2.13) *
0.070191 (2.17) *
- 0.218996 (-5.21) * *
- 0.220270 (-4.65) * *
- 0.157671 (-4.02) * *
- 0.699512 (-9.49) * *
LNREALSIZE
0.000469 (1.09)
0.002424 (4.16) * *
- 0.000915 ( - 1.73)
- 0.009063 (-9.41) * *
HIGHRISK
0.004206 (0.80)
0.009223 (1.93)
0.023982 (6.56) * *
0.028895 (4.15) * *
- 0.000934 (-0.14)
- 0.008746 ( - 1.41)
- 0.027878 (-5.95) * *
- 0.037257 (-5.03) * *
CAPITAL
HIGHRISK * MKT/BOOK
Number of observations Adjusted R 2
258 0.136
258 0.199
602 0.123
36 I 0.407
OLS parameter estimates and associated t-statistics (in parentheses) using the ex-post or year-ending annual standard deviation of finn returns (SDRET) as the dependent variable. The sample consists of 86 commercial banks over the period 1977-1994. MKT/BOOK is the ex-ante or year-beginning market-to-book equity ratio. OPLEV is the ex-ante ratio of book value of fixed assets to total assets. CAPITAL is the ex-ante ratio of book value of equity to total assets. LNREALSIZE is the natural logarithm of the ex-ante real market value of shares outstanding (in millions of 1977 dollars). HIGHRISK is a dummy variable equal to one if the bank has high risk-taking incentives as indicated by an ex-ante market-to-book equity ratio less than 1.0, zero otherwise. * * p-value associated with the t-test for parameter = 0 is significant at the 0.01 level. * p-value associated with the t-test for parameter = 0 is significant at the 0.05 level.
t h a n f o r l o w - i n c e n t i v e s b a n k s . T h u s , t h e r e g r e s s i o n r e s u l t s r e p o r t e d in T a b l e 3 s u p p o r t t h e c l a i m t h a t a n i n e f f e c t i v e r i s k - c o n t r o l s y s t e m in t h e b a n k i n g i n d u s t r y b e g a n a r o u n d 1983, a n d t h a t b a n k s w i t h h i g h r i s k - t a k i n g i n c e n t i v e s a s s u m e d m o r e risk when given the opportunity, During the re-regulatory regime of 1990-1994, we find no support for hypothesis H1 t h a t c h a r t e r v a l u e a n d r i s k - c o n t r o l r e g u l a t i o n s o n c e a g a i n b e c a m e j o i n t l y e f f e c t i v e . I n s t e a d , t h e c o e f f i c i e n t e s t i m a t e s f o r the d u m m y v a r i a b l e a n d i n t e r a c t i o n
522
T.M. Galloway et al./ Journal of Banking & Finance 21 (1997) 509-527
term indicate that banks with high risk-taking incentives continued to take on significantly more bank risk than those with low risk-taking incentives, and that the new regulations did not appear to have a significant impact on risk-taking behavior.
5. Conclusions and policy implications To maintain a sound banking environment, an effective regulatory system must control both a bank's risk-taking incentives and its opportunities to take excessive risk. Traditionally, regulators have utilized two complementary risk-control devices: bank charter value and regulatory supervision. This paper documents the deterioration of the banking industry's risk-control system during the 1980s, and investigates the time-varying relation between a bank's ex-ante risk-taking incentives and its ex-post risk-taking behavior from 1977 to 1994. Using a market-tobook equity ratio to proxy for the bank's charter value and its risk-taking incentives, we test two hypotheses concerning the relation between risk incentives and risk behavior. The first hypothesis states that when the risk-control devices of charter value and regulations are jointly effective, ex-post risk-taking behavior is limited and no different for banks with high and low ex-ante risk-taking incentives, i.e., banks with low and high charter value, respectively. Such an environment existed in the U.S. banking system until the mid-1980s, when market and regulatory developments caused an increase in competition and a decrease in monitoring and foreclosure of problem banks. Consistent with this hypothesis, regression results indicate no statistical difference between the ex-post risk-taking behavior of highand low-incentives banks over the period 1977-1982. The second hypothesis states that when the risk-control devices of charter value and regulations are jointly ineffective, ex-post risk-taking behavior is higher for banks with high ex-ante risk-taking incentives than for banks with low ex-ante incentives. Consistent with this hypothesis, regression results indicate that banks with high risk-taking incentives had significantly higher risk than banks with low risk-taking incentives during the period 1983-1989. Thus, the results provide evidence that banks with high risk-taking incentives actually assumed more risk when given the opportunity. During the re-regulatory regime over 1990-1994, we find no support for the first hypothesis that charter value and risk-control regulations once again became jointly effective. Instead, regression results indicate that banks with high risk-taking incentives continued to take on significantly more risk than those with low risk-taking incentives, and that the new regulations did not appear to have a significant impact on risk-taking behavior. The percentage of problem banks and FDIC losses decreased during the re-regulatory regime. However, the average market-to-book equity ratio, a proxy
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
523
for charter value, remained below 1.0 during this regime, and the percentage of sample banks with high risk-taking incentives was highest in this regime. Thus, the reduction in problem banks during 1990-1994 can more likely be attributed to reduced interest rates, which substantially increased the profitability of banking, than to any real change in risk-taking incentives or opportunities. Our finding of increased risk-taking behavior in the 1980s and the identification of charter value as a self-imposed risk discipline factor have important regulatory implications. Because studies (John et al., 1991; Mishra and Urrutia, 1995) have found that risk-adjusted premiums alone are insufficient to eliminate excessive risk-taking behavior, our results have implications beyond the limited environment of fixed-rate premiums. First, regulatory agents should monitor banks with low charter values more frequently because they have more incentives for moral hazard behavior. Second, bank charter value should be included as a determinant for models in predicting problem banks to facilitate better recognition of problems at an early stage. Third, when regulators have insufficient resources to enforce risk-control regulations, one alternative may be to increase the charter value of the banking industry so that banks have an incentive to self-impose risk constraints. Policies that increase bank charter value include imposing tougher entry requirements and encouraging the corporate control market to discipline under-performing managers. Finally, regulators should not become complacent about the recent improvements in the banking industry. Banks with high risk-taking incentives continue to take on significantly more bank risk than those with low risk-taking incentives. The trend toward lower numbers of problem banks and FDIC losses is largely a result of lower interest rates and improved profitability, and thus, could be reversed if economic conditions change.
Acknowledgements The authors thank Warren Bailey, William Beranek, David Blackwell, Jay Brinkmann, Elizabeth Cooperman, Larry Goldberg, Andrea Heuson, VanSon Lai, Sylvia Hudgins, Charlene Sullivan, and two anonymous referees for helpful comments.
Appendix A. Sample banks 1 2 3 4 5 6
Affiliated Bankshares Colorado Inc Ameritrust Corp Amsouth Bancorp Banc One Corp Banco Popular De Puerto Rico Bancoklahoma C o o
44 45 46 47 48 49
First Virginia Banks Inc Firstar Corp New Fleet/Norstar Financial Corp Fourth Financial Corp Huntington Bancshares Inc Landmark Bancshares Corp
524 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
Bancorp Hawaii Bank of Boston Corp Bank of New England Corp Bank of New York Inc Bank South Corp BankAmerica Corp Bankers Trust NY Corp Banponce Corp Barnett Banks Inc Baybanks Inc Central Fidelity Banks Inc Central Jersey Bancorp Chase Manhattan Corp Chemical Banking Corp Citicorp City National Corp Cititrust Bancorp Colorado National Bancshares Inc Comerica Inc Commerce Bancshares Constellation Bancorp Continental Bank Corp Corestates Financial Corp Deposit Guaranty Corp Dominion Bancshares Corp Equimark Corp Fifth Third Bancorp First Alabama Bancshares Inc First American Corp TN First Bank Systems Inc First Chicago Corp First Commerce Corp New Orleans First Fidelity Bancorp NE First Florida Banks Inc First Interstate Bancorp First Security Corp DE First Tennessee National Corp
50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86
Liberty National Bancorp Inc M N C Financial Inc Manufacturers Hanover Corp Mark Twain Bancshares Inc Marshall and Ilsley Corp Mellon Bank Corp Mercantile Bancorp Inc Mercantile Bankshares Corp Merchants Bank New York NY Merchants National Corp Meridian Bancorp Inc Michigan National Corp Morgan J P and Co Inc NCNB Corp N B DBancorp National City Corp Northern Trust Corp Norwest Corp P N C Financial Corp Republic New York Corp Riggs National Corp Wash DC Santa Monica Bank Security Pacific Corp Shawmut National Corp Signet Banking Corp Society Corp South Carolina National Corp Southeast Banking Corp Southern National Corp State Street Boston Corp U J B Financial Corp Union Planters Corp United Banks Colorado Inc United States Bancorp OR Valley National Corp AZ Wells Fargo and Co Westamerica Bancorp
Appendix B. Sensitivity analysis A l t e r n a t i v e b a n k risk p r o x y . We estimate Eq. (1) using the loan-to-deposit ratio, an accounting-based risk measure, as the dependent variable. The regression
T.M. Gallowayet al./ Journal of Banking & Finance21 (1997) 509-527
525
results are similar to those reported in Table 3, except the coefficient estimates for the market-to-book ratio are significantly negative in the first three regulatory regimes. Alternative charter value proay. We estimate Eq. (1) using the market-to-book asset ratio as a proxy for charter value. This alternative proxy has a correlation of 0.67 with the market-to-book equity ratio. The regression results are very similar to those reported in Table 3, except the coefficient estimates for the market-to-book ratio are significantly positive during the pre-deregulatory and deregulatory periods. Alternative leverage measures. We calculate alternative operating and financial leverage measures based on market value of equity instead of book value of equity. The correlations between the original and alternative values are 0.94 for the operating leverage ratio and 0.38 for the capital ratio. The regression results using the alternative leverage measures are qualitatively similar to those reported in Table 3, except the coefficient estimates for the alternative capital ratio are now positive and insignificant in the first three regulatory regimes. State of incorporation. When we add state of incorporation as an independent variable in Eq. (1), the coefficient estimate of the variable is significant in only the pre-deregulatory and deregulatory regimes, which is consistent with the relaxation of interstate banking restrictions and the trend toward national competition that began in the early 1980s. However, the coefficient estimates of the original variables are very similar to those in Table 3. Too-big-to-fail banks. We designate l 1 banks as too-big-to-fail (TBTF) based on a list published in the Wall Street Journal after the Comptroller of the Currency acknowledged the TBTF policy in testimony before Congress in September 1984. (See O'Hara and Shaw (1990), table V.) The median value of total assets for these 11 banks for 1977-1994 is $55.9 billion compared to $4.4 billion for the remaining 75 banks in the sample. When we estimate Eq. (1) excluding the 11 TBTF banks, there is no substantive effect on the results. Non-bank homing companies. The final sample includes both banks and BHCs. For the BHCs, the balance sheet information obtained from S&P Stock Reports represents the BHC's primary banks. Further, the assets reported do not include anything that is unrelated to normal banking operations. When we exclude the six firms that are not clearly identified by S&P as BHCs and estimate Eq. (1), the regression results are not substantially affected. Risk-based premium structure. It is possible that the change from fixed-rate to risk-based pricing in January 1993 could affect the regression results in the re-regulatory regime. When we limit the re-regulatory regime to 1990-1992 rather than 1990-1994, the basic regression results are unchanged. Confounding effect of deposit insurance subsidy. It is possible that inferences made using the market-to-book equity ratio are suspect due to a confounding effect of the deposit insurance subsidy in the numerator of the ratio. This problem could cause us to pool banks that have high charter values with those that have
526
T.M. Galloway et al. / Journal of Banking & Finance 21 (1997) 509-527
large insurance subsidies. W e identify banks that are more likely to receive a high subsidy as those banks with a market-to-book ratio greater than 1.0, a capital ratio less than 3%, and an equity return variance in the top 25% of the sample. The search yields only three out of 1548 observations in this "insurance subsidy" group. Thus, we conclude that our inferences using the market-to-book ratio are not suspect due to the confounding effect of the insurance subsidy. Multicollinearity. Multicollinearity does not appear to be a severe problem. The strongest pairwise correlation among the independent variables is - 0 . 1 6 for the market-to-book ratio and the size measure. Further, following the procedure of Belsey, Kuh, and Welsch, we examine the four condition numbers from the regressions in Table 3 and find that none exceeds 24. Finally, the variance inflation factors for the four main independent variables in the regressions are less than 1.15 in nearly all cases. Heteroscedasticity. W e use the White specification test to examine whether the regression errors are not independent or not constant. For the four regressions in Table 3, the White chi-square test of first- and second-moment specification shows that the null hypothesis of no misspecification is rejected in only one case (with p-value of 0.0431). For this case, we use W h i t e ' s heteroscedasticity-consistent variance-covariance matrix to calculate adjusted t-statistics, and we find no substantive change from the original results. Autocorrelation. W e use the D u r b i n - W a t s o n d-statistic to examine whether the regression errors exhibit first-order autocorrelation. When we estimate Eq. (1) for each bank over 1977-1994, we do not reject the null hypothesis of zero autocorrelation for 45% of the banks, and the test is inconclusive for the remaining 55% (at the 5% significance level).
References Barth, J.R., R.D. Brumbaugh, Jr. and R.E. Litan, 1992, The future of American banking (M.E. Sharpe, Inc., Armonk, NY). Brickley, J.A. and C.M. James, 1986, Access to deposit insurance, insolvency rules and the stock returns of financial institutions, Journal of Financial Economics 16, 345-371. Buser, S.A., A.H. Chen and E.J. Kane, 1981, Federal deposit insurance, regulatory policy, and optimal bank capital, Journal of Finance 36, 51-60. Christie, A.A., 1982, The stochastic behavior of common stock variances: Value, leverage and interest rate effects, Journal of Financial Economics 10, 407-432. Chung, K.H. and S.W. Pruitt, 1994, A simple approximation of Tobin's q, Financial Management 23, 70-74. Collins, M.C., D.W. Blackwell and J.F. Sinkey, Jr., 1994, Financial innovation, investment opportunities, and corporate policy choices for large bank holding companies, Financial Review 29, 223 -247. Crawford, A.J., J.R. Ezzell and J.A. Miles, 1994, Bank CEO pay-performance relations and the effects of deregulation, Unpublished working paper (Penn State University). DeJong, D.V. and D.W. Collins, 1985, Explanations for the instability of equity beta: Risk-free rate changes and leverage effects, Journal of Financial and Quantitative Analysis 20, 73-94.
T.M. Galloway et al. /Journal of Banking & Finance 21 (1997) 509-527
527
Galai, D. and R.W. Masulis, 1976, The option pricing model and the risk factor of stock, Journal of Financial Economics 3, 53-81. Gaver, J.J. and K.M. Gaver, 1993, Additional evidence on the association between the investment opportunity set and corporate financing, dividend, and compensation policies, Journal of Accounting and Economics 16, 125-160. Gaver, J.J. and K.M. Gaver, 1995, Compensation policy and the investment opportunity set, Financial Management 24, 19-32. Hamada, R.S., 1972, The effect of the firm's capital structure on the systematic risk of common stocks, Journal of Finance 27, 435-452. John, K., T.A. John and L.W. Senbet, 1991, Risk-shifting incentives of depository institutions: A new perspective on federal deposit insurance reform, Journal of Banking and Finance 15, 895-915. Kane, E.J. and H. Unal, 1988, Change in market assessments of deposit institution riskiness, Journal of Financial Services Research 1, 207-229. Kane, E.J. and H. Unal, 1990, Modeling structural and temporal variation in the market's valuation of banking firms, Journal of Finance 45, 113-136. Kaufman, G.G., 1994, The current state of banking reform, Research in Financial Services 6, 281-312. Keeley, M.C., 1990, Deposit insurance, risk, and market power in banking, American Economic Review 80, 1183-1200. Lev, B., 1974, On the association between operating leverage and risk, Journal of Financial and Quantitative Analysis 9, 627-641. Lindenberg, E.B. and S.A. Ross, 1981, Tobin's q ratio and industrial organization, Journal of Business 54, 1-32. Marcus, A.J., 1984, Deregulation and bank financial policy, Journal of Banking and Finance 8, 557-565. Merton, R.C., 1977, An analytic derivation of the cost of deposit insurance and loan guarantees, Journal of Banking and Finance 1, 3-11. Mishra, C. and J.L. Urrutia, 1995, Deposit insurance subsidies, moral hazard, and bank regulation, Journal of Economics and Finance 19, 63-74. O'Hara, M. and W. Shaw, 1990, Deposit insurance and wealth effects: The value of being "too big to fail", Journal of Finance 45, 1587-1600. Perfect, S.B. and K.W. Wiles, 1994, Alternative constructions of Tobin's q: An empirical comparison, Journal of Empirical Finance 1, No. 3/4. Saunders, A., E. Strock and N.G. Travlos, 1990, Ownership structure, deregulation, and bank risk taking, Journal of Finance 45, 643-654.