Credibility of Non-Insurance and Governance as Determinants of Market Discipline and Risk-taking in Banking Penny Angkinand University of Illinois, Springfield & Clas Wihlborg Copenhagen Business School The 2006 CFR Fall Workshop, October 25th

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

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

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

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

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

Figure 1a. Extent of Credible Non-insurance

Hypotheses (from AW 2005) Hypothesis 1 The relationship between risk-taking incentives and explicit deposit insurance coverage is likely to be U-shaped such that (excess) risk-taking is minimized at a positive but partial deposit insurance coverage.

Credibility of Non-Insurance and Risk Taking Effective market discipline Effective market discipline depends on three factors: the coverage of explicit deposit insurance schemes the credibility of non-insurance of those not covered by explicit schemes the relationship between the coverage of explicit insurance and the credibility of non-insurance, which depends on – – institutional and supervisory environment – – bank governance

Factors Affecting the Credibility of Non-Insurance 1. 1.The institutional and supervisory characteristics – – Powers of Supervisors, Powers and Procedures for Prompt Corrective Action, Rule of Law, and Corruption (analyzed in AW, 2005) 2. 2.Bank corporate governance

Hypotheses (from AW 2005) Hypothesis 2 Strengthened institutional environment and supervision enhance the market discipline and therefore reduce risk taking. This reduction in risk-taking is relatively large at low levels of explicit coverage of deposit insurance schemes.

This Paper 1. We extend the argument developed in AW (2005) that the relationship between risk taking and explicit DI coverage is likely to be U-shaped by using bank-specific data. 2. Focus on how the governance of banks affects the disciplinary effect of partial deposit insurance system.

Corporate Governance and Bank Risk Taking “Good” governance: managers maximize shareholders’ wealth. “Good” governance: managers maximize shareholders’ wealth. Governance is influenced by the ownership structures of banks and the explicit or implicit contractual relationship between shareholders and managers. Governance is influenced by the ownership structures of banks and the explicit or implicit contractual relationship between shareholders and managers. Ownership of banks and risk taking Ownership of banks and risk taking – State Ownership – Foreign ownership – Bank concentration (% shares of three largest shareholders)

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

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

Figure 1b. Impact of Bank Governance

Model Specification We estimate the following model specification for risk-taking in bank j in country i in period t: EC = Explicit Deposit Insurance Coverage The effect of CorpGov on the relationship between explicit DI coverage and risk taking: EC 2 i,t  CorpGov j,i,t

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

Proxies for Risk Taking NPL/Capital (Natural Logarithm) “Adjusted” NPL/Total Capital Standard Deviation of NPL/Average of Capital – – Bankscope database – – Proxies for the bank’ willingness to expose the bank to the possibility that loan losses exceed equity capital. – – “Adjusted”: an adjustment factor =

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

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

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

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

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

Empirical Result I: Proxies of Risk Taking First, compare regressions using alternative proxies for risk taking (Table 3) Focus on ln(NPL/Cap) and StdNPL/AvgCapita

Empirical Result II: Credibility of Non-Insurance and Governance Include bank-specific and country-specific corporate governance variables (table 4). Include bank-specific and country-specific corporate governance variables (table 4). Add the interaction terms between corporate governance variables and insurance coverage (Covdepint) (table 5). Add the interaction terms between corporate governance variables and insurance coverage (Covdepint) (table 5).

Table 5 Bank- and country-specific control variables are included, but not reported

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

Empirical Result II: Credibility of Non-Insurance and Governance The County-Level Governance Variables (from Table 4) – – Shareholder rights, creditor rights, and private monitoring have negative effects on risk taking. – – Shareholder rights are significant consistently.

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

Empirical Result II: Credibility of Non-Insurance and Governance Supporting the Hypothesis 3? Compare the signs for the squared covdepint and its interaction term with governance variable. For “Low” quality of governance, the neg. sign of interaction term = a flatter U-shaped, supporting the hypothesis Draw figures describing the relationship between risk taking and DI coverage for different levels of ownership.

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

Foreign Ownership Affecting the Relationship between Risk Taking and DI Coverage

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

Bank Concentration Affecting the Relationship between Risk Taking and DI Coverage

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

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

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