Can strong capital regulation prevent risk-taking from deposit insurance?

Abstract

Can strong capital regulation prevent risk-taking from deposit insurance? Denmark offers a unique setting providing solid identification for testing risk incentives from deposit insurance under strong capital regulation. The Danish system is a universal system without strong risk exposure regulation. Commercial banks and savings banks have different ownership structures but are subject to the same set of regulations, but savings banks have no incentive to increase risk after the implementation of a deposit insurance scheme. We show that commercial banks did not increase their risk at the introduction of deposit insurance compared to savings banks. We attribute this to strong capital requirements and a firm closure policy. The results also hold for large commercial banks, indicating that the systemic risk did not increase either. Finally, there is no evidence that commercial banks increase their risk by allowing their customers to increase their leverage (risk) compared with customers in savings banks.

KEYWORDS:

• Deposit insurance
• moral hazard
• difference-in-difference

JEL Classification:

• G21

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Savings banks tend to use their profits to support activities in the local community.

2 During the time period in question, the management of commercial banks and savings banks did not have performance-dependent pay in the form of options programs, etc.

3 For a discussion of the Danish regulatory system, see (Pozdena 1992); for the use of market value accounting, see (Bernard, Merton, and Palepu 1995)

4 Capital is equity plus certain forms of subordinated debt where 40% of the capital may be provided from subordinated debt.

5 The following institutions went bankrupt: C&G Banken, Fossbankin, Lannung Bank, Samson Bankier, Benzon Bankier, Højderyggens Andelskass, Grølsted Andelskass, Lindknud-Hovborg Andelskass, Bornholmerbanken and Himmerlandsbanken (Mølgaard [1993] and the annual report of the Deposit Insurance Foundation 1995).

6 The regulation in force between 1985 and 1989 can be found on https://www.retsinformation.dk/forms/R0710.aspx?id=66156.

7 This is confirmed by interviews with Eigil Mølgaard and Lars Eskesen as well as by the bankruptcy of C&G Banken in 1987/88 that resulted in losses to depositors.

8 We use subtotals to identify errors by the Supervisory Authority; when the original data does not add up to the subtotals, we drop the institution from the sample from the year of the error. Thus, the number of institutions in our sample differs slightly from the number of institutions indicated in the annual reports.

9 Eigil Mølgaard was head of the Supervisory Authority and was therefore personally informed and involved in all the acquisitions. In his book (Mølgaard 2003, 67), he identifies banks in financial distress during our period of 1985–1992.

10 Building loans and mortgage loans on banks’ financial statements are from customers requiring financing for building a house. Upon completion, the customer obtains long-term financing from a mortgage institution and redeems the loans in the bank.

11 SDS, Bikuben, Sparekassen Sønderjylland, Skive Sparekasse, Sparekassen Fåborg, Sparekassen Nordjylland and Sparekassen Sydjylland.

12 The conversion had to be approved by the guarantors and/or the depositors. It is not clear how these "bondholders" were convinced to become shareholders unless they received a pay-off. We have not been able to ascertain how this was done in practice, but guarantors probably received a small overpayment on their certificates.

13 We also undertook an analysis using instrumental variables for the status of the institution (lagged status, existence of foreign branches prior to 1982, and growth). Neither of the instruments worked. Thus, an IV regression would probably do more harm than good.

14 Since 1883, Greens Handbooks have collected information on ownership structure, financial statements, and board members for Danish firms.

15 The model was also estimated as a fixed effect model (dropping Post and the macroeconomic variables) with doubled clustered errors with no qualitative differences.