Reciprocal deposits and incremental bank risk

Abstract

Even after controlling for other observable factors, reciprocal deposits are associated with higher bank risk as measured by the probability of failure and the Z-score. These results are consistent with the moral hazard hypothesis and reject the risk substitution hypothesis.

Keywords:

• reciprocal deposits
• bank risk
• logit
• failure
• Z-score

JEL Classification:

• G21
• G32
• D82

Notes

1 This requirement is stipulated in Section 1506 of the Dodd-Frank Act; see Adler (2011).

2 The most common such product is CDARS, offered by Promontory Interfinancial Network, LLC. A similar product has been patented by Intrasweep LLC.

3 This Z-score, which represents a distance to default, is not the same as Altman’s Z-score, which is used in corporate finance and fixed income studies.

4 Some studies use a hazard model rather than a logit model, but both types of models have found similar financial ratios to be significant predictors of failure.

5 This window of 21 months is within the 12- to 24-month failure window used by most early warning studies.

6 Prior studies have documented abnormal performance for younger banks (De Young and Hasan, 1998; Shaffer, 1998)

7 Banks were also excluded if they reported equity growth exceeding 100% per quarter from the prior December.

8 The highest ratio in the sample was 44.4%.

9 Recall that banks in the sample exhibited reciprocal deposit ratios as high as 44%.

10 The unconditional mean probability of failure within the sample window is 1 665 827 = 0.02849.

11 An alternate specification using annualized September and year-to-date June figures, not reported here, gave qualitatively similar results when banks with excessively large Z-scores were excluded due to the possibility of strategic earnings smoothing by banks. Note that quarterly Z-scores will typically exceed annual Z-scores due to smaller quarterly standard deviations of ROA; the sample average for the first three quarters of 2009 was 322.68 with a SD of 576.73.