Journal of Comparative Policy Analysis: Research and Practice 3: 59–83 (2001)
c 2001 Kluwer Academic Publishers. Printed in The Netherlands.
How Does Regulation Affect the Risk Taking
of Banks? A U.S. and Canadian Perspective
JILL M. HENDRICKSON
[email protected]
University of the South, 735 University Avenue, Sewanee, TN 37383-1000
MARK W. NICHOLS
University of Nevada, Reno, NV 89557
Key words:
commercial banking, U.S. banking, Canadian banking, regulation, risk
Abstract
This historical study utilizes annual insured bank data from 1936 through 1989 to empirically evaluate the impact of bank regulation on bank risk taking in a cross-country comparison of the United
States and Canada. Risk is hypothesized to be determined, in part, by the regulatory environment in
which a bank operates. The findings of this analysis contributes to the contemporary deregulation
policy debate, since both branch banking restrictions and deposit insurance variables are found
to be detrimental to bank stability. More specifically, these results support the 1994 Riegle–Neal
Interstate Banking and Branching Efficiency Act, which removed legislative barriers to interstate
branching. These results also confirm expectations that deposit insurance increases risk taking and
supports the 1991 mandate by regulators that risk-based deposit insurance be created. Further,
these findings support the 1988 Basel Accord to standardize bank capital requirements internationally and to link these standards to bank risk taking.
Introduction
The structure of the U.S. commercial banking system has been undergoing
prodigious change in the last two decades, and with the recent wave of mergers and proposed bills for deregulation, further change is inevitable. Within
the last two decades, the banking system has been transformed by several
important developments: failure rates not seen since the Great Depression;
deregulation of a regulatory structure constructed largely as a response to
the Great Depression; a rise in the number, and size, of bank mergers; and
a large influx of competition from nonbank institutions. In response to these
developments, scholars and policymakers are reevaluating the bank regulatory
environment in attempts to reestablish a stable and profitable banking system. Though many of the policy proposals that have been advanced call for
continued deregulation, others caution that deregulation may further disrupt
and destabilize the system at a time when greater uncertainty and increased
competition characterize the banking environment. By examining the historical
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performance of banking relative to the regulatory structure, the present article
offers insight into the contemporary debate surrounding the deregulation of
commercial banking in the U.S. Specifically, this study considers what impact
the postwar regulatory structure had on the propensity towards risk taking of
commercial bankers. This result is accomplished by comparing the U.S. postwar
regulatory structure with that in Canada and using this comparison to explain
risk.1 In addition to bank risk, this study also examines the relationship between
regulation and the incidence of bank failures, which, obviously, is related to bank
risk.2
While there are limits to making cross-country comparisons, the historically
comparable levels of economic development and similar social and political
environments in these two countries make Canada and the U.S. natural choices
for comparison.3 Moreover, the stark contrast between the two countries in
terms of their regulatory environment and the number of bank failures deserves
attention. This is especially true given the growing body of literature postulating
that regulation has exacerbated the problem of bank instability.
The next section reviews the literature on the relationship between U.S. bank
regulation and instability. The purpose of financial regulation and a discussion of
the historically different regulatory environments between the U.S. and Canada
follow. Our models of bank risk and failures, as well as the empirical results, are
then presented followed by our conclusions.
Competing theories of bank regulation
Two general theories of regulation, namely, the public interest approach and
the self-interest theory, attempt to explain why regulation is relied upon in market systems. The public interest approach to regulation suggests that regulatory measures are designed to protect against market failure, notably natural
monopoly, imperfect information, and externalities (Litan and Nordhaus, 1983).
Under the public interest approach, bank regulation, such as deposit insurance
and limitations on investment activity, exist for the benefit of the consumer. Bank
regulation, for example, protects the consumer’s assets and reduces depositor
exposure to the risk of bank failure and insolvency.
In contrast, the “capture’’ or self-interest theory of regulation, introduced by
Stigler (1971) and later expanded by Peltzman (1976) and others, suggests that
interest groups seek regulation primarily for the benefits it produces for them.
For banks, such regulation might be in the form of restricting entry into banking
services and limiting access to potential substitutes.
Commercial banking has long been one of the most regulated industries in
the U.S. Legal restrictions and requirements (e.g., strict reserve requirements,
prohibition on branching, and collateral requirements against currency) were
placed on the first state and nationally chartered banks. The current regulatory
structure stems largely from the Banking Acts of 1933 and 1935, both of which
were introduced as a consequence of the Great Depression and associated
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
61
bank crisis. This regulatory structure appears to have increased stability during
the first few decades (see Figure 1), but more recently there has been an increase
in the number and size of bank failures. This pattern has led to a debate over
regulation’s impact on bank stability.
In his book, What Should Banks Do?, Litan (1987) notes that “most banks
were primarily limited to accepting deposits and making loans; to conducting
business in their home states or even home countries; and to paying interest on
deposits at rates no higher than federally authorized ceilings.” He further notes
that “the various limitations were designed to ensure the safety and soundness
of depository institutions, to prevent conflicts of interest that could distort credit
allocation, and to minimize aggregations of wealth and political power.”
Based on the above work of Litan (1987), it appears as though banking
regulation was, at least initially, consistent with the public interest theory of
regulation. If this is so, why the recent call for deregulation? Won’t deregulation harm consumer’s and destabilize the industry? Indeed, many other scholars espouse the public interest theory of regulation. Spong (1990), for example, advances three overriding objectives of bank regulation: protection of depositors, stability of the payments system, and promotion of an efficient and
competitive bank sector. Regulation to protect depositors under a fractional
reserve system came primarily in the form of federal deposit insurance following the losses to depositors during the Great Depression. Regulating deposit activity, e.g., deposit interest rates, deposit use, and deposit insurance,
enhances monetary stability because of the crucial role commercial banks
play in controlling the amount of money in the economy. Finally, bank regulation ensures that competitive prices exist on services such as loans and
deposits.
Edwards and Scott (1979), on the other hand, argue that the fundamental objective of financial regulation is to preserve the solvency of banking institutions
(1979, p. 66).4 In the process, depositor assets may be protected and the monetary system stabilized, but these consequences are secondary to the goal of
minimizing insolvencies.
More specifically, Edwards and Scott argue that the Federal Reserve’s role
of lender of last resort, federal deposit insurance, and a host of detailed regulation (e.g., price controls, activity restrictions, entry restrictions, and balance
sheet requirements) are all meant to protect the solvency of commercial banks
in the U.S. While deposit insurance may appear to be directed at protecting the
individual depositor, its primary purpose is to reduce or eliminate bank runs.
Similarly, price controls (e.g., deposit rate ceilings), entry restrictions (e.g., limits on intrastate and interstate branching and charter requirements), and activity restrictions (e.g., partial separation of commercial and investment banking)
all limit competition and protect banks from failure. Finally, regulated balance
sheet requirements, such as capital requirements, are defended on grounds
that holding capital reduces banks’ susceptibility to deposit withdrawals and
failure.
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Figure 1. Annual number of failed banks: 1936–1989. Note the scale change for Canadian banks.
This is to provide a view of Canadian bank failures.
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
Figure 2.
Average asset value of failed banks: 1934–1989 (dollars in thousands).
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Edwards and Scott conclude, however, that such a regulatory environment is
excessive. Many of the existing regulations are ineffective or counterproductive.
Further, the lack of competition in banking imposes a high cost on society.
Therefore, selective deregulation would improve social welfare.
In contrast to the work of Spong or Edwards and Scott, other scholars suggest
that the recent instability in the U.S. commercial banking sector is a consequence of excessive government regulation and changing economic conditions.5 Litan (1987) notes that the environment in which banks operate has
changed dramatically in recent years. In particular, high inflation, which drove
up interest rates and spawned the explosion of money market mutual funds
and other substitutes for traditional bank deposits, and rapid advances in
information technology have made obsolute the depression era controls placed
on banking. Indeed, faced with this changing economic and competitive environment and the inability to diversify into other lines of business, the very
regulation that was intended to ensure bank solvency now threatens that
stability.
In later work, Litan (1997) classifies bank regulation into two paradigms: the
prevention–safety net paradigm and the competition–containment paradigm.
The prevention–safety net paradigm describes the post-Depression era of bank
regulation in the United States in which the regulators sought to prevent further individual bank failures and, at the same time, expanded a safety net to
protect individual depositors and creditors from loss. Regulations under this
paradigm include limits on bank activity, capital standards, and deposit insurance. Litan argues that the intent of this regulation has been to minimize the
risk of bank failure and depositor loss. However, he would also argue that these
very regulations, which aimed at minimizing risk and enhancing stability, ultimately were responsible for creating incentives for increased risk taking by the
U.S. commercial banker and for destabilizing the commercial bank sector. This
outcome stems from the dynamic nature of the financial sector (i.e., advances
in information technology, innovation and increased competition by nonbanks,
and globalization) and the inability of prevention–safety net regulation to accommodate change.
Because of the prevention–safety net paradigm’s inability to contain risk and
promote stability in a dynamic financial sector, Litan calls for a new paradigm
that is aimed at maintaining stability in a more competitive and evolving market. The new paradigm, known as the competition–containment paradigm, calls
for changing regulations to allow banks to compete with nonbanks and calls
for isolating and containing problems, preferably before crises occurs. Litan
believes that we must move away from the post-Depression paradigm because it, in part, now encourages excessive risk taking. The new paradigm
will, in part, minimize excessive risk taking by the commercial banker, even
though there will be more competition. Thus, according to Litan, bank regulation has contributed to bank instability and risk taking in the past 30 or so
years.
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
65
Many other scholars paint a picture of U.S. bank regulation that is similar to
that of Litan. For example, Pierce (1991) and White (1993) argue that the set of
post-Depression era regulation is defined by two primary objectives, namely, to
minimize competition and to create a federal safety net to protect consumers.
The federal safety net, largely composed of deposit insurance, is said to encourage risk taking because of the moral hazard associated with it. However, Pierce
argues that the instability of deposit insurance does not reveal itself until banks
are subject to increased competition and falling profitability. Both these developments occurred in the United States in the early 1970s. Since then, banking
has been an increasingly dynamic enterprise subject to increased competition
and changing balance sheet and off-balance sheet activity. Constrained and
encouraged by regulation, banks have taken on increasingly risky projects in
this new era of dynamic banking.
Boot et al. (1999) also argue that the increasingly dynamic nature of commercial banking has increased risk taking by banks constrained by regulation. These
scholars characterizes bank regulation into one of two types: direct and indirect. Direct regulation defines certain behavior or permissible activity for banks
and other financial institutions. The separation of commercial and investment
banking and prohibitions on interstate banking are examples of direct regulation in the United States. Indirect regulation, in contrast, does not prescribe
behavior but, rather, uses both price and nonprice means to elicit certain behavior from the banker. Risk-based capital standards and deposit insurance
premiums are examples of such regulation. Both are meant to discourage risk
taking by making the loss to the bank greater (more costly) should the action
fail. Boot et al. (1999) argue that in a dynamic market, direct regulation tends
to be more problematic for bank performance, since the regulation remains
static while the market moves in unpredictable directions. From this perspective, whether or not bank regulation is stabilizing may depend, to a large degree,
on whether the regulation is direct or indirect and also on whether the financial sector is experiencing rapid growth and change or if it is maintaining the
status quo.
Perhaps the most obvious form of regulation is federal deposit insurance.
Moral hazard problems arise because of flat-rate insurance premiums independent of bank risk (see, for example, White, 1993; Benston, 1991; McKenzie,
1990; O’Driscoll, 1988; Benston and Kaufman, 1986; Shiers, 1994; Bhattacharya
et al., 1998). Instability increases because bankers have an incentive to increase risk. Moreover, depositors often perceive all insured banks as homogenous and consequently fail to monitor and discipline the banks using their
funds.
Finally, it is also argued that bank regulation has promoted a fragmented
banking system by prohibiting interstate branching.6 Salsman (1993), Benston
and Kaufman (1986), and Benston (1991) suggest that a prohibition against
branching leads to less diversified banks that are more susceptible to local economic downturns and shocks. Wheelock (1992) provides supporting empirical
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evidence by examining the performance of Kansas banks in the 1920s, finding that limits on branching caused banks to be more vulnerable to economic
shocks.
In many ways, Salsman’s (1993) historical analysis captures the essence of the
body of literature advancing a positive relationship between bank regulation and
instability by demonstrating that private bankers have continuously innovated
to restore stability to a system made unstable by government intervention and
regulation:
When restrictions imposed on note issue under the National Banking System caused money panics, they [bankers] developed “clearinghouse certificates’’ and other forms of private currency that consumers demanded. When
restrictions imposed by the Glass–Steagall Act in the 1930s prevented banks
from underwriting securities and doing business with the best U.S. companies, they invented term loans. When branching and new product opportunities were blocked by law and narrowly constrained banks in the 1950s, they
created holding companies to permit growth and diversification. When interest rate ceilings and restrictions on deposit gathering, together with inflationdriven high interest rates, led to an outflow of deposits in the 1960s and 1970s,
they created certificates of deposits and “Eurodollar’’ accounts. When central banking brought volatility to foreign exchange markets and interest rates
in the 1970s and 1980s, they created hedging products to enhance stability.
More recently, in response to central banking’s double-digit growth rates in
money and credit that ballooned bank balance sheets and dwarfed capital,
they invented “securitization,’’ the process of preserving liquidity and capital
adequacy by packaging loans and selling them in the secondary markets. To
the extent that there has been any stability in the banking sector under central banking, it has been achieved by the creative efforts and skilled private
bankers—in spite of central banking, not because of it (110–111).
In summary, the role of regulation in promoting stability is ambiguous. Regulation designed to protect depositors, reduce risk taking, and prevent failures is
said, by critics, to have had the exact opposite effect. Therefore, the impact regulation has on risk taking and bank stability is ultimately an empirical question.
A brief comparison of bank regulation between the U.S. and Canada
Policymakers in Canada and the U.S. have used bank regulation in varying
amounts and degrees to achieve the objectives outlined above. Specifically,
six provisions of banking regulation historically differentiate the operating environment of Canadian and U.S. banks: capital-asset requirements, permissible
investment activity, permissible loan activity, restrictions on deposit interest
rates, branch banking rights, and deposit insurance. Table 1 provides a concise
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
Table 1.
67
Relevant chronology and description of banking regulation
Regulation
United States
Canada
• Prior to 1981: capital requirements were determined by
regulatory agencies’ subjective examination of individual
banks, whereby capital levels
were compared to levels of
similar banks (see Keeley,
1992, p. 147).
• December, 1981: risk-based
capital requirements were
established.
• Prior to 1980: bank managers
were responsible for determining
capital levels.
Investment activity
• Prior to 1933: commercial
banks established securities
affiliates or used their bond
departments for securities
underwriting and distribution.
• Banking Act of 1933: partially
separated commercial and
investment banking, though
commercial banks were still
allowed to underwrite federal
government securities and
state and municipality bonds.a
• Prior to 1980: commercial banks
were able to directly underwrite
and distribute government securities and to underwrite and distribute corporate securities.
• Bank Act of 1980: required that
the distribution and underwriting
of corporate securities utilize subsidiaries (see Kryzanowski and
Roberts, 1992).
Lending activity
• National Banking Act of 1864:
limited permissible product
line to commercial loans.b
• DIDMCA 1980: lifted remaining
lending restrictions for all
depository institutions.
• Prior to 1967: limited permissible
product line to commercial loans.
Capital–asset
requirements
• Bank Act of 1980: empowered
the Inspector General to set minimum capital requirements (see
Kryzanowski and Roberts, 1992).
• 1944–1967: loan interest ceiling of
6%.
• Bank Act of 1967: liberalized permissible lending activity and lifted
interest ceiling.
Deposit interest
• Banking Act of 1933: placed a
3% ceiling on time and savings
deposits and prohibited interest payments on demand
deposits.
• Late 1960s–1970s: interest
ceiling adjusted upwards to
minimize disintermediation.
• DIDMCA 1980: phased-out interest ceiling.
• Prior to 1967: 6% interest ceiling
on deposits.
• Bank Act of 1967: allowed banks
to pay market interest rate on
deposits.
(Continued on next page.)
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Table 1.
HENDRICKSON AND NICHOLS
(Continued).
Regulation
Branch banking
Deposit Insurance
United States
• National Bank Act of 1864: interpreted to limit nationally chartered
banks to a single location.
• State Chartered Banks: branching
rights and restrictions determined
on state-by-state basis.
• 1927 McFadden Act: afforded nationally charted banks the opportunity to branch within the city
of the parent bank, provided that
state law afforded similar opportunities to state banks.
• Banking Act of 1933: national
banks were given authority to establish intrastate branches provided that state law allowed it.
• Bank Holding Company Act of
1956c : prohibited interstate acquisition of banks by bank holding
companies.
• Bank Act of 1993: created federal
deposit insurance available to all
commercial banks.
Canada
• Banks have always been allowed
to establish branch units throughout Canada.
• Prior to 1967: implicit deposit insurance for all commercial banks.
• 1967 Bank Act: created federal deposit insurance for all commercial
banks.
a See Kelly (1985) for a detailed history of securities activity by U.S. commercial banks, and Kaufman (1988) for more recent changes.
b Lending restrictions were liberalized slowly over time, e.g., the Federal Reserve Act of 1913
granted nationally chartered banks the right to extend farm mortgages. Huertas (1987, p. 140)
discusses the segmentation of U.S. lending activity.
c Including amendments in 1970 and 1979.
summary of the regulatory differences between the two countries and indicates
the relevant chronology of change to the regulatory structures.
Generally, Canadian banks have been less regulated than U.S. banks. On the
asset side, lower capital requirements and more liberal securities and lending
activity characterize the Canadian banking system. On the liability side, usury
ceilings on deposits were higher in Canada. Moreover, the ceilings were lifted
sooner in response to rising interest rates in the late 1960s. Branch banking
opportunities clearly favor the Canadian system. Canadian banks have always
been allowed to establish a nationwide network of branches. In contrast, myriad
legislation has attempted to clarify U.S. branching rights and limit interstate
banking.7 While federal deposit insurance was made available to U.S. commercial banks in 1933, explicit deposit insurance was not introduced in Canada
until the 1967 Bank Act created the Canada Deposit Insurance Corporation.
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
69
Nonetheless, Canadian banks had enjoyed an implicit deposit guarantee since
the early 1920s (Kryzanowski and Roberts, 1992). Prior to 1967, regulators and
government officials worked together to ensure the solvency of Canadian banks
by standing ready to lend to, or find healthy banks to acquire, troubled banks.
Essentially, implicit deposit insurance was created through the Canadian government’s policy of guaranteeing all deposits at par. While Canadian bankers
did not pay insurance premiums, they benefited from a government policy that
was equivalent to deposit insurance. This implicit insurance created depositor
and borrower confidence in the banking system and allowed Canadian banks
to hold relatively fewer noninterest-bearing assets.
Collectively, the individual regulations reviewed above create distinct environments for the Canadian and U.S. banking sectors, with the Canadian system
characterized as less regulated than the U.S. system.8 By comparing these two
countries with different regulatory environments and failure rates, the role of
regulation as a stabilizing or destabilizing factor can better be inferred. The
next section describes the data and model specification used for quantifying
the impact of these regulatory differences on risk taking and the number of bank
failures.
Data and bank risk model
In creating a model of bank risk, this study utilizes annual balance sheet and
income/expense data for U.S. and Canadian commercial banks for the years
1936–1989.9 The use of annual aggregate data implies that our study considers the “average’’ bank for both countries. Data on Canadian banks come
from Canada Year Book, Bank of Canada Review, and Historical Statistics of
Canada. Data for insured commercial banks in the U.S. come from the FDIC Historical Statistics on Banking and the 1991 Annual Report of the FDIC. All data
are adjusted for inflation using each country’s GNP deflator and are expressed
in 1989 U.S. dollars.
Before presenting our risk model, we test for stationarity in each individual
time series. If series are nonstationary, it can lead to spurious results when
the levels of variables are used for estimation. However, Granger (1981) shows
that nonstationary variables may have linear combinations that are stationary
without differencing. If so, the series are said to be cointegrated.
Using the augmented Dickey–Fuller test, each series, with the exception of
the unemployment rate, is found to be nonstationary. However, first differencing results in all series being stationary. Using Johansen’s (1988) multivariate
cointegration test, we find the regulatory variables to have at least two cointegrating equations, indicating that the series given in models (1) and (2) below possess a long-run equilibrium relationship. Consequently, the estimation
of these bank risk and failure models uses levels rather than first differences.
However, because of serial correlation revealed through ordinary least squares
(OLS) estimation of the risk model, the technique of first-order autoregressive
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HENDRICKSON AND NICHOLS
(AR(1)) correction is employed. Thus the OLS results of the risk model are all
AR(1) correction estimates.
Model construction utilizes a set of explanatory variables meant to capture the regulatory differences between the two nations. Further, the model
includes a set of general control variables, X t , to account for such factors as
changing macroeconomic conditions that might affect bank risk. The result is a
linear model meant to capture how different regulatory regimes impact bank risk
taking:
RISKt = β0 + β1 (KAGAPt−1 ) + β2 (DEPGAPt−1 ) + β3 (LOANGAPt−1 )
+ β4 (SECGAPt−1 ) + β5 (BANKSIZEt−1 ) + β6 (PCTINSt−1 )
+ β x X t + εt .
(1)
Each variable is defined next, along with a discussion of the expected
results.
Dependent variable
The dependent variable, RISKt , is defined as the difference in the five-year
moving average of the standard deviation of the return on capital for each
country.10 As such, it captures differences in bank risk taking between the two
countries.
Regulatory variables
The set of regulatory variables is defined as the U.S. value less the Canadian
value. Further, the variables are all lagged one period to minimize potential simultaneity bias. KAGAPt−1 is the difference in capital-asset ratios and captures
differences in capital requirements. LOANGAPt−1 represents the difference in
loan returns for the two nations. SECGAPt−1 reflects return on security differences created by the two regulatory regimes and captures, in part, investment
restrictions that allow U.S. banks to only hold investment grade securities compared to Canada’s more liberal investment activities. The impact of Regulation
Q is proxied by DEPGAPt−1 , the difference in total deposits per capita between
the U.S. and Canada.11 Further, differences in branch banking laws are proxied
through BANKSIZEt−1 , defined as total assets over the number of banks. Branch
banking may lead to scale economies that result when establishing branch units
lead to lower overhead, labor, and other costs (see Bordo, Rockoff, and Redish,
1994; Kryzanowski and Roberts, 1992; Nathan and Neave, 1992). Finally, Shiers
(1994) accounts for the moral hazard problem elicited by deposit insurance by
including the percent of all insured deposits. Therefore, PCTINSt−1 , the percentage of total deposits insured, is included in model (1) to capture the impact of
deposit insurance.
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
71
As outlined above, most banking regulation is intended, either directly or indirectly, to enhance the stability and solvency of banks by protecting them from
interbank competition or reducing their exposure to risk. Branching restrictions
and charter requirements protect existing banks from competition and entry.
Interest rate ceilings prevent price competition for deposits. Loan restrictions
segment the market, thereby reducing competition between banks and other
financial intermediaries. Further, the partial separation of commercial and investment banking laws also limits competition. These barriers to competition
may protect banks that may not remain solvent in an otherwise competitive
market.12 In terms of risk-taking incentives, Regulation Q controls the cost of obtaining deposits and may therefore limit the incentives for high-risk/high-return
lending and investing practices. Similarly, capital requirements may constrain
excessive risk taking, particularly in the face of underpriced deposit insurance.
On the other hand, the very existence of regulation may provide incentives
for those participating in the intermediation process to increase their risktaking behavior. Regulation may reduce the opportunities for diversification
(e.g., restrictions on permissible investment activity, loanable funds, and branch
banking) and hence increase portfolio risk.13 Capital requirements limit the
amount of funds available for lending or investment and may also increase
risk taking. Further, interest rate ceilings, while reducing interbank competition,
may also lead to disintermediation problems when market interest rates rise
above regulated rates. Consequently, if disintermediation outweighs the stabilizing nature of regulation, we would expect regulation to increase risk taking by
bankers. Deposit insurance is also thought to encourage risk taking because of
the moral hazard problems associated with it. Perhaps this tendency was even
more true in Canada when its insurance was explicit rather than implicit, since
the banker bore none of the insurance costs yet benefited from the protection
and depositor confidence.
Other control variables
Several control variables were also created to account for real sector performance and regulatory developments throughout the sample period. A trend
variable, TRENDt , controls for macroeconomic or other exogenous shocks that
may have affected bank failure rates. UNEMt−1 controls for fluctuations in unemployment rates in the U.S. and Canada, and BUSFAILt−1 accounts for the
average liabilities of failed business enterprises. Higher values of both variables may increase bank risk. Finally, as is well known, regulatory structures
were not constant during the sample period. In 1980, significant legislative
changes were made in both the U.S. and Canada. The Depository Institutions
Deregulation and Monetary Control Act (DIDMCA) of 1980 drastically changed
the regulatory landscape by phasing out Regulation Q, increasing deposit insurance from 40,000 to 100,000, and liberalizing lending activity.14 In Canada,
the revisions to the Bank Act of 1980 extended bank powers to the activities
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HENDRICKSON AND NICHOLS
of leasing and factoring, further reduced required reserves, removed securities underwriting, and eased entry requirements. These regulatory changes
are controlled for with YEAR80t , a dummy variable equal to 1 for the years
1980–1989.
Failure model
In addition to the risk model, we also offer a failure model meant to illustrate the robustness of model (1). The model for testing the effectiveness of
U.S. bank regulation in stabilizing the commercial bank sector utilizes Tobit
regression analysis, since many of the observations are clustered at zero. Failure model construction includes the same set of regulatory and control variables from model (1) and adds a set of risk variables found in the bank failure
literature:
FAILt = β0 + β1 (KAGAPt−1 ) + β2 (DEPGAPt−1 ) + β3 (LOANGAPt−1 )
+ β4 (SECGAPt−1 ) + β5 (BANKSIZEt−1 ) + β6 (PCTINSt−1 )
+ β7 (LARISKt−1 ) + β8 (MGMTt−1 ) + β9 (RERATIOt−1 )
+ β x X t + εt .
(2)
The dependent variable, FAILt , is the annual percent of insured U.S. commercial banks that failed over the period 1936–1989. Thus, the data reflect
a regulatory bank failure and not necessarily the precise date of bank insolvency. Certainly, there are often discrepancies between the time when a bank
becomes insolvent and the time when regulators declare the bank to have
failed. This gap may arise, for example, because of different incentives facing regulators charged with closing insolvent institutions (Kane, 1989). While it
is important to consider the incentive structure facing regulators when examining the period of time until failure (Demirguc-Kunt, 1989), the current study
focuses on differences in regulation between the U.S. and Canada and the role
these play in explaining differences in aggregate bank failures between the two
countries.15
While the independent regulatory and control variables are defined as in
model (1), this failure model also includes two specific risk variables. As suggested in Avery and Hanweck (1984), bank loans are the most illiquid of bank
assets and subject to the greatest threat of default. Consequently, the ratio of
total loans to total assets, LARISKt−1 , reflects U.S. banks’ exposure to default
risk. Asset quality may also be proxied as ratios of specific types of loans to
total loans. Since many local bank failure studies attribute real estate loans as
contributing to the large number of U.S. bank failures in the 1980s, this study
utilizes the ratio of real estate loans to total loans, RERATIOt−1 , as a second
measure of asset quality.16 Finally, mismanagement or fraud may also lead to
bank failures. Following Pantalone and Platt (1987), the ratio of total interest
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
73
expense to total liabilities, MGMTt−1 , measures management efficiency. Naturally, it is expected that lower risk will result in fewer bank failures.17
Empirical results
Risk model
Table 2 contains descriptive statistics for the variables used in models (1) and (2).
Table 3 contains the results for the risk model and indicates that all the regulatory
variables are of the expected sign and, except for the capital requirement proxy
and the security returns variable, statistically significant.
The coefficient for differences in capital requirements, KAGAPt−1 , is negative,
indicating that higher capital holdings in the U.S. decreases bank risk. Greater
capital holdings may provide a source of funds that protect banks from failure in the face of unexpected deposit withdrawals or loan defaults and may
constrain risk taking. The positive coefficient for differences in security returns,
SECGAPt−1 , suggests that limits placed on U.S. banks’ security activity reduces
bank risk, possibly by limiting the volatility and uncertainty often associated with
securities dealings. Thus, both the capital requirements and securities regulation seem to enhance bank stability, supporting Garrison, Short, and O’Driscoll
(1988), who argue that asset restrictions and capital requirements limit the moral
hazard of deposit insurance by preventing banks from taking full advantage of
underpriced deposit insurance.
Similarly, the positive coefficients on DEPGAPt−1 and LOANGAPt−1 suggest
that regulation that limits interest paid on deposits and the type of permissible loan activity is effective in reducing bank risk. This outcome suggests that
the effect of limited costs and competition introduced with Regulation Q outweighed any destabilizing effect brought about by disintermediation. Moreover,
the positive sign of DEPGAPt−1 supports Rolnick (1987), who finds a positive
correlation between deposit rates and bank risk. Over the sample period, lower
loan returns appear to have been associated with decreased risk and limited
competition.
In contrast, the negative and statistically significant coefficient on BANKSIZEt−1 indicates that the freedom to operate branch units reduces bank risk.
This finding suggests that smaller banks may be less diversified, operating
with riskier portfolios and therefore more prone to failure.18 Similarly, larger
banks may have a greater ability to raise new capital and reduce insolvency
in volatile or uncertain times. Finally, the positive and significant coefficient
on the percent of deposits insured, PCTINSt−1 , suggests not only that deposit
insurance increase risk but also that it ultimately promotes instability in the
banking system. Therefore, if insurance is to be provided, it should be a function
of risk, as mandated by the 1991 Federal Deposit Insurance Improvement Act,
rather than a simple flat fee. This approach would diminish the agency problem
and promote stability.
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HENDRICKSON AND NICHOLS
Table 2.
banksa .
Descriptive statistics for insured U.S.
Variable
Insured U.S. Banks
FAILt
KAGAPt−1
DEPGAPt−1
0.0022
(0.0040)
−0.0991
(0.175)
1938.37
(453.03)
LOANGAPt−1
−0.0022
(0.010)
SECGAPt−1
−0.0235
(0.021)
BANKSIZEt−1
PCTINSt−1
−15.260
(12.827)
57.50
(10.60)
LARISKt−1
0.4315
(0.139)
MGMTt−1
3.1464
(5.917)
RERATIOt−1
0.2481
(0.024)
TRENDt−1
UNEMt−1
BUSFAILt−1
YEAR80t
34.50
(15.73)
6.4259
(3.760)
405.81
(235.66)
0.1852
(0.039)
a Variable means. Standard deviation in parentheses.
Not surprisingly, BUSFAILt−1 is significant at the 5% level, suggesting that
banks are susceptible to the health of the economy and borrowing enterprises.
A negative and significant YEAR80t suggests that bank risk has decreased
following much of the regulatory reform of 1980s. Finally, TRENDt is statistically
significant at the 5% level and shows a small decline in bank risk over the period,
ceteris paribus.
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
75
Table 3. OLS coefficients for insured
banks: risk model.
Variable
KAGAPt−1
Estimated coefficient
−0.00033
(1.04)
SECGAPt−1
0.049
(1.41)
LOANGAPt−1
0.493a
(1.83)
DEPGAPt−1
0.004a
(1.79)
BANKSIZEt−1
PCTINSt−1
−0.0086a
(2.01)
0.039b
(2.52)
YEAR80
−0.026b
(3.32)
UNEMt−1
0.011b
(2.79)
BUSFAILt−1
0.088a
(1.85)
TRENDt
0.009b
(3.24)
CONSTANT
−9.382b
(3.27)
AR(1)
0.099a
(5.27)
R2
84.38
DW
1.94
a Significance
at the 10% level.
at the 5% level.
Note: Absolute values of the t statistic
appear in parentheses.
b Significance
Failure model
Much like the risk model results, the failure model results found in Table 4
provide conflicting evidence for the hypothesis that regulation increases instability. While all the regulatory variables are statistically significant, some types
of regulation are found to reduce failures, while others are found to increase the
number of bank failures.
More specifically, two of the regulatory variables are found to reduce bank
failures. The negative coefficient to KAGAPt−1 indicates that the higher capital requirements in the U.S. reduce failures, an outcome that is consistent
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HENDRICKSON AND NICHOLS
Table 4. Tobit and adjusted tobit coefficients for insured
banks: failure model.
Variable
Tobit
Adjusted Tobit
−0.0392b
(3.44)
−0.00016
DEPGAPt−1
0.0839b
(2.48)
0.0638
LOANGAPt−1
0.193b
(2.32)
0.0938
SECGAPt−1
0.0837a
(1.92)
0.0411
−0.0015b
(4.39)
−0.00392
KAGAPt−1
BANKSIZEt−1
PCTINSt−1
0.00183b
(3.29)
0.00099
LARISKt−1
0.0617
(1.09)
0.0182
MGMTt−1
0.00283b
(3.41)
0.00055
RERATIOt−1
0.0288
(0.83)
0.0083
−0.034b
(3.57)
−0.00129
UNEMt−1
0.0038
(1.07)
0.00011
BUSFAILt−1
0.000114b
(4.03)
0.000005
YEAR80t
0.0382a
(2.08)
0.058
TRENDt
CONSTANT
−0.098b
(2.65)
LR Testc
95.49b
a Significance
−0.0038
at the 10% level.
at the 5% level.
c Likelihood ratio test ∼χ 2 (13), where null is that all coefficients except the constant are zero.
Notes: Absolute values of the t statistic appear in parentheses.The adjusted Tobit coefficient reflects the change in the
dependent variable (for those observations above the limit
of zero) caused by a change in the independent variable.
Specifically, it equals βi∗ {1 − ( f (z)/F(z)) ∗ (z + f (z)/F(z))},
where βi is the Tobit coefficient, z = Xβ/s, f (z) is the normal
density, and F(z) is the normal distribution. See McDonald
and Moffit (1980).
b Significance
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
77
with the findings in the risk model. Similarly, the positive coefficient for differences in the return on securities suggests that the lower securities return
in the U.S. decreases failures—a finding that is, again, consistent with the risk
model. The findings from the failure model differ in one other aspect from the
risk model: increases in unemployment rates are found to increase risk slightly,
whereas they are found to be statistically insignificant in the failure model. This
outcome suggests, perhaps, that macroeconomic conditions play an important role in risk taking but not to such a degree as to contribute to actual
failure.
All the risk variables are positive, suggesting that, ceteris paribus, higher risk
increases failure rates. However, only the management efficiency coefficient
is statistically significant. This finding suggests that management control over
interest expenses reduces bank failures. Both LARISKt−1 and RERATIOt−1 are
insignificant, with the latter result likely reflecting that the widely publicized
problems of real estate loans were concentrated in regional markets and insignificant from the perspective of the “average’’ U.S. bank.
Conclusions
The findings of this study suggest that certain regulations contribute to bank
risk taking and failures, while others tend to stabilize the industry. This finding further suggests that blanket reforms, where all aspects of the industry are
deregulated, may not be an appropriate policy. While restrictions on branch
banking and deposit insurance are found to be destabilizing, regulations on
allowable investments and loan types, and on the price of deposits, have the
opposite effect. This outcome corroborates the conclusions of Edwards and
Scott (1979), who find that selective deregulation in areas such as branch
banking and price controls will increase stability and welfare but that balance sheet controls, especially liquidity and equity requirements, should be
maintained.
The finding that asset restrictions and capital requirements work to constrain
bank risk in the presence of moral hazard problems supports the 1999 Gramm–
Leach–Bliley Act, which repealed the Glass–Steagall provisions and the 1991
mandate for repricing deposit insurance to reflect bank risk. This finding also
reveals the interdependence among various regulations. Since policymakers
expanded banks’ security investment activity, it is necessary for deposit insurance to be a function of risk in order to limit the incentives for excessive
risk taking. Further, the finding that branch banking restrictions destabilize U.S.
banking supports the 1994 Riegle–Neal Interstate Banking and Branching Efficiency Act, which allows banks to branch across state lines if state law allows.
Finally, these findings indicate that higher capital holdings reduce both bank
risk and the number of failures. In this way, the findings provide support for
the 1988 Basel Accord that sets risk-sensitive capital requirements for banks
across the globe.
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HENDRICKSON AND NICHOLS
Although the present study suggests that differences in regulatory regimes
may explain differences in risk taking and bank failure rates, another possible
explanation may be found in differences in regulator behavior. For example,
political pressure, regulator prestige, postemployment opportunities, etc. may
all play into a bank closure decision. In the U.S., the practice of regulatory forbearance during the thrift crisis of the 1980s serves as an important example in
which regulators extended survival time. If the incentives facing regulators vary
between the U.S. and Canada, regulator behavior may also explain discrepancies in bank failure rates. Indeed, determining whether regulator incentives vary
between the U.S. and Canada and, if so, how to incorporate these differences
into an empirical model of bank risk and failures is an excellent topic for future
research.
Clearly, the list of regulations that may contribute to bank risk has not been
exhausted in this study (e.g., the 1977 Community Reinvestment Act, the 1983
International Lending Supervision Act).19 Nonetheless, this comparative study
between the U.S. and Canadian banking systems provides insight into understanding both the relationship between regulation and risk and the number of
bank failures. This, in turn, provides some insight into the relationship between
bank stability and regulatory policy that may be helpful in the contemporary
deregulation debate. The fact that all the regulatory variables in this model are
significant suggests that regulation plays an important role in influencing the
performance of commercial banking, so discussions of policy must be taken
seriously.
Finally, the findings of this study may shed some light on the theoretical
debate of whether or not regulation promotes stability in commercial banking. No consensus exists as to why banks are heavily regulated: is it to protect depositors or to promote and protect industry participants? These
empirical findings, which are consistent with much of the theoretical literature,
suggest that regulation aimed at promoting safety and soundness, such as deposit insurance, probably fails to advance consumer welfare. Further, to the
extent that regulation is destabilizing, consumer welfare is certainly not advanced. Nonetheless, it is difficult to determine the true intent of banking, or
any, regulation because at times the consumer may benefit and at other times
the regulated participants benefit. Indeed, this division of benefits between
the consumer and industry is consistent with Peltzman’s (1976) discussion of
the politics of price-entry regulation. In particular, pure producer protection
(the capture theory) is only rational in the absence of any consumer opposition, and pure consumer protection (the public interest theory) is only rational
in the absence of any producer opposition. Given opposition on both sides,
the regulator will find it politically attractive to obtain a balance between the
two.
At the same time, however, there is more theoretical consensus that regulation
in banking has tended to be increasingly destabilizing as the macroeconomy has
become more dynamic (See Competing Theories of Bank Regulation above).
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
79
The results of this study corroborate this consensus by demonstrating that
important regulation on commercial banking increases risk taking. Specifically,
deposit insurance and restrictions on interstate banking are both found to exacerbate risk, and therefore, during times of greater uncertainty and change in the
industry, it is easy to envision more pressure and opportunity for risky behavior.
In the case of deposit insurance, moral hazard problems tend to increase in the
face of greater uncertainty, which is the outcome we have witnessed during the
past 30 years. Further, deregulation in 1994 removed interestate banking barriers, and commercial banking has seen greater stability and prosperity since
1992. Although one cannot attribute such prosperity directly to deregulation,
these findings suggests that the deregulation does play a role in stabilizing
commercial banking.
Appendix: Data—variable definitions
Variable
Definition
FAIL
Percent of annually failed banks calculated as Number of failed insured
commercial banks/total Number of insured commercial banks.
RISK
Standard deviation of the return on capital in U.S. minus standard deviation
of the return on capital in Canada.
KAGAP
Capital–asset ratio in U.S minus capital–asset ratio in Canada.
SECGAP
Return on securities in U.S. minus return on securities in the Canada
Return on securities is calculated as Interest Income on Securities/Total
Securities.
LOANGAP
Return on loans in U.S. minus return on loans in Canada. Return on loans
is defined as Total Income from Loans/Total Loans.
DEPGAP
Total deposits per capita in U.S. minus total deposits per capita in Canada.
BANKSIZE
Average bank size in U.S. minus average bank size in Canada. Average
bank size is defined as Total Assets/Number of Banks in billions of U.S.
dollars.
PCTINS
Percent of total deposits in insured banks that are covered by deposit
insurance.
LARISK
Total loans divided by total assets.
MGMT
Total interest expense divided by total liabilities.
RERATIO
Real estate loans divided by total loans.
TREND
Trend variable equal to one if Year = 1936, two if Year = 1937, etc.
UNEM
U.S. unemployment rate, in percent, minus Canadian unemployment rate,
in percent.
BUSFAIL
Total liabilities, in millions, of commercial failures divided by the number of
commercial failures.
YEAR80
Dummy variable equal to one if Year ≥ 1980.
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HENDRICKSON AND NICHOLS
Acknowledgments
Our sincere thanks for their comments to the participants in a 1996 Western
Economics Association session and to three anonymous referees. All remaining
errors are those of the authors.
Notes
1. In the context of our empirical analysis, the terms risk and risk taking refer to increased chances
for failure. This is not to say that all forms of risk taking are undesirable or that all regulators
view risk taking in this way. Indeed, risk taking in the form of innovation, entrepreneurship, etc.
is necessary and vital for economic prosperity and may be stabilizing. However, our use of the
term risk taking throughout this article should be equated with increased likelihood of failure.
2. See Figure 1, which shows the number of bank failures in Canada and the U.S. for the period
1936–1989, and Figure 2, which shows the asset value of failed banks for the sample period.
3. See, for example, Bordo, Rockoff, and Redish (1994) for a comparison of profit levels between
the two countries.
4. Gilbert (1975, p. 7) also argues that a primary objective of bank regulation is the prevention of
bank failures.
5. For an interesting historical interpretation of increasing bank regulation consistent with this
viewpoint, see Horwitz (1993).
6. Further, some states prohibited intrastate branching. For example, in 1933, 11 states prohibited
intrastate banking and 17 states limited intrastate branching. These numbers changed very
little during our sample period because, in 1982, 10 states still prohibited the establishment
of branch units, and the number of states that placed restrictions on intrastate branching had
increased to 26 (see Moore, 1995).
7. The passage of the 1994 Riegle–Neal Interstate Banking and Branching Efficiency Act changed
branch regulation in the U.S. by allowing banks to branch across state lines, provided that state
law allows it. See Maggs and Pate (1995) or Kane (1996) for a discussion of the Act.
8. Swary and Topf (1992, p. 459) classify the Canadian banking regulation as “mild” and the U.S.
banking regulation as “heavy.”
9. Although individual bank data would have been desirable, they are not available for this entire
time period. Further, it has been suggested that perhaps the instability of the 1980s may play
a large role in the overall findings of this model. To test the robustness of the model for the
entire time period, the model was also regressed for the period 1936–1979, and the results
were statistically the same as those generated using the entire sample.
10. See the Appendix for a complete description of all variables in the model.
11. Total deposits per capita, rather than the interest paid on deposits per capita, is used because
of multicollinearity problems with the loan interest rate.
12. See O’Driscoll (1988, p. 5) who argues that the reduction in bank failures following the Great
Depression was due not to increased bank safety but rather to the result of reduced competition
via regulation.
13. Benston (1991, pp. 226–227) finds that regulation limits diversification and hence reduces individual bank stability.
14. The 1982 Garn–St. Germain Act, also an important legislative development, focused primarily
on the troubled thrift industry. It is not controlled for within this study for this reason; more
importantly, a dummy variable for the 1982 Act would be highly collinear with the 1980 dummy
variable. Nonetheless, several provisions related to commercial banks included a more rapid
phaseout of Regulation Q, the introduction of money market deposit accounts to compete with
money market mutual funds, and an increase in the national bank lending ceiling to individual
borrowers. These provisions are consistent with the deregulation of U.S. banking in the 1980s.
HOW DOES REGULATION AFFECT THE RISK TAKING OF BANKS?
81
15. An important contribution to recent bank failure literature does consider the empirical question
of how long a bank will survive. Typically, such studies utilize cross-sectional data over a short
period of time to understand bank survival time and rely on regression techniques known as
survival models. For example, Cole and Gunther (1995) utilize a split-population survival time
model to explain both bank failures and bank survival time. They find that, in general, different
sets of variables explain bank failures and survival time. Calomiris and Mason (1997) use a survival duration model to forecast Chicago bank survival times during the Great Depression. Both
studies compare a population of failed institutions against a population of surviving institutions
using panel data.
16. Other asset quality ratios, such as commercial and industrial loans to total loans, and agricultural
loans to total loans, produced results similar to the real estate ratio.
17. Another commonly included risk variable is the capital-to-asset ratio (see, e.g., Avery and
Hanweek, 1984). This variable is included in the current specification and as discussed above
in the previous subsection.
18. These results are consistent with those of Benston (1991, p. 226).
19. These and a host of other regulatory developments make it costlier for banks to operate. Compliance and other cost data are not separately available for inclusion in this study.
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Jill M. Hendrickson is an Assistant Professor of Economics at the University of the South in
Sewanee, Tennessee. Her area of specialty is money and banking, with emphasis on the impact of
regulation on bank performance and behavior.
Mark W. Nichols joined the faculty of the Department of Economics at the University of Nevada,
Reno in July 1996. Nichols’s area of specialty is industrial organization and public policy.