The recent financial crisis highlights the importance of both regulatory and market discipline, which seem to have been lacking in some cases. One of the reactions of government authorities in the United States (US) and the European Union (EU) was to increase deposit insurance coverage. In the US, the deposit insurance cap on the dollar amount of funds insured was raised from $100,000 to $250,000. In the EU, moves were made to eliminate co-insurance and raise the deposit insurance coverage caps. Government authorities in both the US and EU also came to the rescue with capital injections and government takeovers of many large and in some cases, not so large banking organizations, which may have had the effect of expanding the coverage of financial institutions that are considered to be too big or too important to fail.
The obvious goals of both sets of actions was to reduce panic and the potential for bank runs and other disruptions in the short term, but a potential long-run consequence may be a reduction in depositor discipline that might otherwise penalize banks for risk-taking behavior. Thus, short-run solutions to excessive bank risk taking might reduce the impediments to excessive risk taking in the long run.
To examine the potential for this to occur, we test for the presence of depositor discipline effects in the period leading up to the financial crisis in both the US and the EU. Specifically, we examine the effects of measures of bank risk on both deposit growth and deposit risk premiums for over 2000 commercial banks and bank holding companies in the US and 22 EU nations over the period 1997-2007. For expositional convenience, we will often refer to both organizational types as “banks.” We run tests separately for US and EU banking organizations to see if there is a different effect due to the generally lower deposit insurance coverage in the EU.
There may also be differences due to the expected likelihood of government bailouts in the event of bank failures. We also run tests separately on institutions above and below $50 billion (real 1997 dollars) in total assets to see if there is a different conjecture about the likelihood of too-big-to-fail protection in the US and EU. We also separately examine the extent of depositor discipline of listed versus unlisted banking organizations due to the more widespread information known about listed institutions, although we acknowledge that the measured effect may go the other way because listed institutions have more financial ratios available, so that the reaction to any one ratio may be more muted. Finally, we test to which types of financial indicators depositors react, capital ratios or measures of loan performance, the latter of which may be easier for the institutions to manipulate.
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Do Depositors Discipline Banks?
