1. Depositors response to deposit insurance reforms: Evidence from Japan, 1990-2005 Masaru Konishi Hitotsubashi University and Ikuko Fueda Japan Center for Economic Research

2. Motivation 1.Do depositors play a disciplinary role on riskier banks by requiring higher interest rates or/and by withdrawing their funds? 2.Do fully insured and partly uninsured depositors respond to bank risk differently? 3.Does a rapid withdrawal of deposits from risky banks force the banks manager to aggressively restructure bank management?

3. Method Using data from Japanese banks during the 1990 to 2005 period, we empirically investigate (1)how depositors respond to various measures for bank financial conditions, and (2)how the management of risky banks respond to various disciplinary devises: depositor, shareholder, and regulatory discipline.

4. Major Results 1.Depositor discipline by deposit withdrawal was most significant during the period of full insurance coverage rather than during the period of limited insurance coverage. 2.There is little evidence of depositor discipline by requiring higher interest rates on riskier banks. 3.Deposit withdrawal induces bank managers to carry out aggressive restructuring.

5. Brief review of the related studies (1): Market discipline Interest rates on large CDs: Hannan and Hanweck (1988), Ellis and Flannery (1992), Brewer and Mondschean (1994), Cook and Spellman (1994) Risk premium of subordinated debts: Flannery and Soresue (1996), Evanoff and Wall (2001), Morgan and Stiroh (2001) No evidence of an effect of bank risk on the risk premium of subordinated debt: Avery et al. (1988), Gorton and Santomero (1990)

6. Brief review of the related studies (2): Depositor response to bank risk Depositor discipline by withdrawing deposits and requiring higher interest rates: –U.S. evidence: Park (1995), Park and Peristiani (1998) –Intl evidence: Martinez-Peria and Schmukler (2001) (Argentina, Chile, and Mexico) Depositor discipline by withdrawing deposits: – U.S. evidence from failing S&Ls: Goldberg and Hudgins (1996, 2002), Maechler and McDill (2006) –Japanese evidence: Hosono (2003) Depositor discipline by requiring higher interest rates –Cross-country evidence: Demirguc-Kunt and Huizinga (2004) No evidence of depositor discipline – Gilbert and Vaughan (2001)

7. Contributions 1.Examine depositor discipline in a financial system different from the U.S. 2.During the 1990-2005 period, the Japanese financial system experienced a series of changes in deposit insurance regimes: –The adoption of unlimited protection of all deposits in 1995 –The reinstatement of a 10 million yen deposit insurance cap on time deposits in 2002 –The reinstatement of a 10 million yen deposit insurance cap on demand deposits in 2005 3.Examine not only the necessary condition but also a sufficient condition for the existence of depositor discipline.

8. Chronology of deposit insurance reforms in Japan 1971: Japan established a deposit insurance system. 1974: The insurance coverage was increased from 1 mil. yen to 3 mil. yen. 1984: The insurance coverage was increased to 10 mil. yen. June 1995: The govt declared full protection for all deposits until March 2001. Dec. 1999: The govt postponed the reinstatement of the insurance cap for one year for time deposits (now April 2002) and two years for demand deposits (now April 2003). April 2002: Reinstatement of the insurance cap for time deposits only. Oct. 2002: The govt postponed full implementation of the insurance cap by two years (now April 2005). April 2005: The insurance cap was finally set to be fully implemented!

9. Hypotheses Hypothesis 1: Depositors seek to discipline risky banks by withdrawing their deposits. Hypothesis 2: Depositors require higher interest rates on deposits at riskier banks. Hypothesis 3: Uninsured depositors are more responsive to bank financial conditions than insured depositors are. Hypothesis 4: The deposit withdrawal induces bank managers to engage in restructuring of banking operations.

10. Sample selection and data Unbalanced panel data of Japanese banks (city banks, regional banks, tier-two regional banks, credit associations, and credit cooperatives) covering the period from 1990 to 2005. Data source: Nikkei Financial Quest database, Annual Financial Statements of credit associations and credit cooperatives Our sample consists of 5,436 bank-year observations.

11. To conclude that depositor discipline is present, we need to show: 1.The growth of deposits is negatively and interest rates are positively associated with bank risk, or 2.The growth of deposits is negatively associated with bank risk but the interest rates are not related to bank risk, or 3.Interest rates are positively associated with bank risk but the growth of deposits is not associated with bank risk

12. Method (1): Test of depositor discipline via deposit withdrawal from riskier banks DEPOSIT: growth rate of total, demand, and time deposits CAPITAL: capital ratio BADLOAN: the ratio of nonperforming loans to total assets ROA: the ratio of net business profits to total assets CASH: the ratio of liquid assets to total assets ASSET: natural log of total assets (Both fixed effects and time effects are controlled.)

13. Method (2): Test of depositor discipline by demanding higher interest rates on riskier banks INTERESTRATE: interest payments by a bank on its deposits at the end of year t divided by the total amount of deposits averaged between beginning and the end of the year t.

14. Test periods 1.1990-1994: 10 million insurance caps for both demand and time deposits; a period of forbearance policy 1990-1992 1993-1994 2.1995-2001: Full protection for all kinds of deposits 1995-1996 1997-2001: A period of financial crisis 2001: The year preceding the partial reinstatement of insurance cap on time deposits 3.2002-2004: Full protection for demand deposits, but not for time deposits 4.2005: 10 million insurance caps for both demand and time deposits

15. Figure 1 Proportion of demand and time deposits for households and firms from April 1999 to April 2006

16. Method (3): Test of the importance of deposit withdrawal as a means of enforcing bank restructuring RESTR: the rate of change in operating expense, personnel expense, nonpersonnel expense, number of employees and number of branches DEPOSIT: deposit growth depositor discipline LISTED: a dummy variable that equals 1 if a bank is publicly traded shareholder discipline BISGAP: a banks capital ratio minus the regulatory required ratio regulatory discipline PUBLIC: a dummy variable that equals 1 if a bank was recapitalized under Early Strengthening Law

20. Summary of the results 1.Depositor discipline by deposit withdrawal was most significant during the period of full insurance coverage rather than during the period of limited insurance coverage. 2.There is little evidence of depositor discipline by requiring higher interest rates on riskier banks. 3.Deposit withdrawal induces bank managers to carry out aggressive restructuring.

21. Why was depositor discipline most significant during the period of full protection? 1.Depositors were very cautious about bank risk because of the collapse of a few major banks in 1997 and 1998. 2.The Prime Minister announced in July 2002 that settlement-only accounts would be fully protected even after the full reinstatement of the deposit insurance cap. 3.Depositors might have taken protective measures, such as spreading their deposits over several banks, before the removal of full protection for demand deposits in April 2005.