1 “Credibility of Non-Insurance and Governance as Determinants of Market Discipline and Risk-Taking in Banking”: Discussion Edward J. Kane Boston College FDIC Fall Workshop October 25, 2006

2 Professors Angkinand and Wihlborg Investigate Two Questions: I. How do deposit-insurance coverage and corporate-governance variables affect the ability of market forces to “discipline” individual-bank risk taking? II. How does a country’s macroeconomic environment affect the answer to question I? Takeaway: Corporate-governance characteristics and deposit-insurance coverage interact differently in industrialized vs. emerging-market countries.

3 THE AUTHORS’ EMPIRICAL EVIDENCE ON THESE QUESTIONS COMES FROM WHAT EDWARD LEAMER WOULD CHARACTERIZE AS AN “HYPOTHESIS- TESTING SPECIFICATION SEARCH”  Multiple Specification Experiments: Numerous proxies for bank riskiness are regressed in several econometrically interesting ways on numerous individual-bank and macroeconomic country variables.  Single-Equation Methods: Main goal is to explain proxies for risk that deflate either the level of a bank’s nonperforming loans (NPL) or its standard deviation by some measure of the bank’s total capital or assets. [No attempt is made to account for differences in the definition, economic significance, or exposure to loss of NPLs in different countries.]  Interpretation: Policy lessons are drawn by stressing coefficients whose sign and significance prove relatively robust across experiments.

4 AN AWFUL LOT IS JAMMED INTO THIS PAPER

5 AUTHORS’ INTERPRETATION OF COEFFICIENT PATTERNS IS UNDERMINED BY AN INCOMPLETE AND SHIFTING IDEA OF THE GOAL THAT A BANK SUPERVISOR SHOULD PURSUE In identifying relevant literature and in deriving testable hypotheses about the effects of deposit-insurance coverage, the discussion shifts back and forth unwisely between three incomplete and inconsistent goals for supervisory activity: 1) Controlling (sometimes even minimizing) bank risk taking. [This criterion neglects the potential social benefits of bank risk-taking]; 2) Eliminating so-called “excessive” risk- taking [but “excessive” is not defined]; 3) Minimizing the probability of a banking crisis [omits the projected costs of possible crises and the deadweight burdens that might be generated by the control instruments used].

6 RISK TAKING IS THE SALT AND SUGAR OF GOOD BANKING  The authors need to introduce controls for the kinds of loans a country can generate. In a country whose investment opportunity set consists predominantly of risky positive NPV projects, it would be economically efficient for banks to show high and variable levels of nonperforming loans and bank creditors and regulators should be prepared to supervise them accordingly.  This clarifies again that NPLs have different meaning in different countries in different times.  Most economists would frame the public-policy problem of bank supervision as a search for a way to fashion relatively neutral interventions into bank loan decisions.  Differently focused ways do exist to determine when safety-net arrangements, corporate governance, and other country characteristics do and do not promote not risk-taking, but risk-shifting.

7 Risk-shifting occurs whenever a contractual counterparty is exposed to loss from fraud, leverage or earnings volatility without being adequately compensated for the risk entailed. A country’s Deposit Insurer controls its own loss exposure by imposing a combination of ex ante and ex post risk premia. When marginal premia are set too low, a bank can shift risk onto its deposit insurer in two principal ways: increasing its leverage (B/V) increasing the volatility of return on assets (σ V ).

8 A. How valuable are unconstrained increases in leverage and volatility? B. How strongly do capital requirements discipline volatility? C. Do officials generate enough supervisory and regulatory pressure to offset the private bonding and depositor discipline that government guarantees displace? ISSUES

9 Risk-shifting is subsidized whenever the value of the explicit and implicit deposit guarantees to a country’s banks exceeds the sum of the ex ante and ex post premia the insurer imposes on them. Ex post premia are important. Without them, ex ante premia can always be arbitraged. To avoid subsidizing bank risk taking, a deposit insurer must monitor and police leverage and volatility activities ex post.

10 Ideal coefficient signs are α 1 < 0 and β 1 < 0. IPP= γ 0 + γ 1 σ v + γ 2 (B/V) + ε 1,(1) B/V =  0 +  1  V +  2   his structural model has the reduced form: IPP =  0 +  1  V +  3.(3) The Authors Could Study Risk-Shifting With BancScope Data  Empirical literature on how safety nets affect risk-shifting seeks to measure how well authorities have controlled risk-shifting incentives in different countries.  The standard way to do this is to synthesize robust estimates of the “fair” insurance premium per dollar of insured deposits (IPP) and of the volatility ( V ) of bank returns from the behavior of bank stock prices and relate these variables to balance-sheet leverage using the following structural equations:  The standard way to do this is to synthesize robust estimates of the “fair” insurance premium per dollar of insured deposits (IPP) and of the volatility (σ V ) of bank returns from the behavior of bank stock prices and relate these variables to balance-sheet leverage using the following structural equations:

11 1. By expanding this specification, Hovakimian, Laeven, and I show that: Cross-country variation in the extent of safety-net subsidies is explained by variation in: Deposit-Insurance Design Quality of Contracting Environment (Transparency, Deterrency, Bonding, and Government Accountability)

12 High IPP Supervisory Regimes Typically Subsidize Risk-Taking. High-Subsidy Countries Invite Crisis.  A banking crisis occurs when a sufficient amount of bad luck hits a banking system whose managers have made their institutions vulnerable to this amount and type of bad luck.  Vulnerable banking systems resemble sinkholes, in that they are accidents waiting to happen. Intersectoral risk- shifting activity generates an unseen sinkhole of unbooked government debt. The odds and severity of breakdown increase as the unbooked government guarantees implicitly drain off more and more taxpayer wealth.

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