Deposit-Insurance--Risk--and-Market-Power-in-Banki

AmericanEconomicAssociationiscollaboratingwithJSTORtodigitize,preserveandextendaccesstoTheAmericanEconomicReview.(s):MichaelC.KeeleySource:TheAmericanEconomicReview,Vol.80,No.5(Dec.,1990),pp.1183-1200Publishedby:AmericanEconomicAssociationStableURL::26-05-201506:59UTCYouruseoftheJSTORarchiveindicatesyouracceptanceoftheTerms&ConditionsofUse,[e-mail]m180.160.2.13onTue,26May201506:59:07UTCAllusesubjecttoJSTORTermsandConditionsDepositInsurance,Risk,andMarketPowerinBankingByMICHAELC.KEELEY*Afixed-ratedepositinsurancesystemprovidesamoralhazardforexcessiverisktakingandisnotviableabsentregulation.AlthoughthedepositinsurancesystemappearstohaveworkedremarkablywellovermostofitsS0-yearhistory,majorproblemsbegantoappearintheearly1980's.Thispaperteststhehypothesisthatincreasesincompetitioncausedbankchartervaluestodecline,whichinturncausedbankstoincreasedefaultriskthroughincreasesinassetriskandreductionsincapital.(JEL600)Ithaslongbeenrecognizedthatafixed-ratedepositinsurancesystem,suchastheFederalDepositInsuranceCorporation's(FDIC's),ortheFederalSavingsandLoanInsuranceCorporation's(FSLIC's)canposeamoralhazardforexcessiverisktaking.Thereasonisthatbanksorthriftscanbor-rowatorbelowtherisk-freeratebyissuinginsureddepositsandtheninvestingthepro-ceedsinriskyassetswithhigherexpectedyields.AsRobertC.Merton(1977)hasshown,depositinsurancecanbeviewedasaputoptiononthevalueofabank'sassetsatastrikepriceequaltothepromisedmaturityvalueofitsdebt.Underafixed-ratesystem,bankspotentiallycantransferwealthfromtheinsuringagency,and,absentregulation,banksseekingtomaximizethevalueoftheirequitywillmaximizethevalueoftheputbyincreasingassetriskand/orminimizingin-vestedcapitalrelativetoassets.Empiricalresearch,however,doesnotseemtoshowthatbanksingeneralmaxi-mizetheputoptionvalue.Foronething,manybanksholdsubstantiallymorecapitalthantherequiredamounts(MichaelC.Keeley,1988)andforanother,researchershavefoundthatformanybanks,thevalueofthedepositinsuranceoptionislessthanitsprice(AllanJ.MarcusandIsraelShaked,1984;EhudRonnandAvinashK.Verma,1986;GeorgePennacchi,1987),assumingthatattheexpirationoftheoptioninsolventbanksareclosed.Moreover,formostofits50-yearhistory,theinsurancesystemhasbeencharacterizedbylowfailureratesandlowpayouts-justtheoppositeofwhatmightbeexpectedifbanksweremaximizingthevalueoftheputoptionsuccessfully.Recently,bankandthriftfailuresandde-positinsurancepayoutshavereachedrecordhighs(seeChart1);theFSLIChasliabili-tiesfarinexcessofitsassets,andeventheFDICfacesthreatstoitssolvency.Althoughmanyhavearguedthattheserecentprob-lemsareinpartduetothemoralhazardofdepositinsurance,thequestioniswhyithastaken50yearsformajorproblemstoarise.Oneexplanation(ArnoldKling,1986)isthattherecentepisodesimplyreflectsanincreasinglyriskyeconomy,whichinturnhasincreasedtheriskofbankportfolios.Inthelastfewyears,wholesectorsandregionsofthenationalandeventheworldeconomyhaveencounteredseriousdownturnsthat*VicePresident,CornerstoneResearch,1000ElCaminoReal,MenloPark,CA94025.MuchoftheresearchinthispaperwasconductedwhiletheauthorwasaresearchofficerattheFederalReserveBankofSanFrancisco.However,opinionsexpressedhereinarethoseoftheauthoranddonotnecessarilyreflecttheviewoftheFederalReserveBankofSanFrancisco,theBoardofGovernorsoftheFederalReserveSys-tem,orCornerstoneResearch.AnearlierversionofthispaperwaspresentedatGarnInstituteofFinance'sacademicsymposiumondepositinsurance.CommentsfromWilliamBeaver,JackBeebe,BarbaraBennett,MarkFlannery,ChristopherJames,EdKane,StuartMyers,RandallPozdena,AnthonySaunders,andtwoanonymousrefereesaregreatlyappreciated.AliceJacobsonprovidedexpertresearchassistance.Theusualcaveatsapply,however.1183Thiscontentdownloadedfrom180.160.2.13onTue,26May201506:59:07UTCAllusesubjecttoJSTORTermsandConditions1184THEAMERICANECONOMICREVIEWDECEMBER1990ExpensesperDepositNumberof(Percent)Failures0.13-1800.12-0.11a1500.10av0.09a1200.08l0.07Expenses/Depositsa*900.06-..0.05-0.04600.030.02a*300.01'aFailures0.00I________________________________525456586062646668707274767880828486CHART1.DEPOSITINSURANCEEXPENSESPERDOLLAROFDEPOSITSANDBANKFAILUREShaveaffectedthevaluesofbankandthriftassets.Similarly,interestrateshavebecomemorevolatile,increasingtheriskinessofbanks',andespeciallythrifts',portfolios.Theriseinbankandthriftfailuresinrecentyearsalsomayreflecttheseculardeclineincapital-to-assetratiosoverthepasttwodecades.AsChart2shows,bothmarketandbookcapitalratiosofthe25largestbankholdingcompanieshavefallenwellbelowtheirlevelsinthemid-1950's,whenonlyahandfulofbanksandthriftsfailedeach