Rethinking moral hazard: government protection and bank risk-taking (original) (raw)

The Effect of Capitalization on Bank Risk in the Presence of Regulatory and Managerial Moral Hazards

Journal of Bank Management, 2008

We investigate the relationship between banks' capitalization and risktaking behavior. The conventional wisdom is that well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases with capitalization. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom. First, many studies neglect agency problems arising from the separation of management and ownership. Second, past studies rely on limited risk-return profiles of the asset choice set and do not consider profiles in which higher risk is associated with higher return.

The Effect of Capitalization on Banks' Risk under Regulation and Managerial Moral Hazard: A Theoretical and Empirical Investigation

2004

We investigate the relationship between banks' capitalization and risktaking behavior. The conventional wisdom is that well-capitalized banks are less inclined to increase asset risk, because the option value of deposit insurance decreases with capitalization. There are, however, at least three shortcomings in the existing theories that cast doubt on the validity of the conventional wisdom. First, many studies neglect agency problems arising from the separation of management and ownership. Second, past studies rely on limited risk-return profiles of the asset choice set and do not consider profiles in which higher risk is associated with higher return.

Bank governance, regulation and risk taking

2009

This paper conducts the first empirical assessment of theories concerning relationships among risk taking by banks, their ownership structures, and national bank regulations. We focus on conflicts between bank managers and owners over risk, and show that bank risk taking varies positively with the comparative power of shareholders within the corporate governance structure of each bank. Moreover, we show that the relation between bank risk and capital regulations, deposit insurance policies, and restrictions on bank activities depends critically on each bank's ownership structure, such that the actual sign of the marginal effect of regulation on risk varies with ownership concentration. These findings have important policy implications as they imply that the same regulation will have different effects on bank risk taking depending on the bank's corporate governance structure.

Investor protection, regulation and bank risk-taking behavior

The North American Journal of Economics and Finance, 2019

This paper examines whether the influence of investor protection on banks' risk is channeled through banking regulation, and vice-versa, using panel data from a sample of 567 European and US banks for the 2004-2015 period. As banking regulatory factors, we consider capital stringency, activity restrictions and private monitoring, whereas as investor protection factors, we consider the level of shareholder and creditor protection. We find that banking regulation moderates the positive direct influence of investor protection on banks' risk, while investor protection reinforces the negative direct influence of banking regulation on risk. Moreover, we show that the negative effect of national regulations on banks' risk is more pronounced during systemic crisis years. Finally, taking into account market competition, we argue that private monitoring only has a direct effect on banks' risk, whereas the effects of capital stringency and activity restriction are channeled through market competition.

Regulatory and governance impacts on bank risk-taking

Risk Management, 2018

Risk in financial institutions is vitally important to regulators, policy makers, investors, and the stability of the financial system, yet some critical aspects of that risk remain poorly understood. In the case of U.S. startup banks, a critical choice that can influence risk-taking behavior is which of three regulators-with varying levels of stringency-to choose. The board of directors of the new bank makes this important decision, which may result in different risk implications, depending on board's structure. Here, we examine banks' risk behavior associated with the degree of board independence and the choice of regulator. We find that the regulatory environment and board independence jointly influence new bank risk. Our evidence suggests that the intensity of regulatory scrutiny is a partial substitute for board independence in achieving an optimal level of risk. We discuss the implications of our findings for theory and policy.

Market Discipline, Disclosure and Moral Hazard in Banking

2006

This paper investigates the effectiveness of market discipline in limiting excessive risk-taking by banks. We have constructed a large crosscountry panel data set consisting of observations on 729 individual banks from 32 different countries over the years 1993 to 2000. Theory implies that the strength of market discipline ought to be related to the extent of the government safety net, the observability of bank risk choices and to the proportion of uninsured liabilities in the bank's balance sheet. We test for hypotheses relating to all of these factors at the bank level. Panel data estimation techniques are applied to both capital regressions, which aim to explain banks' choice of capital buffers, and risk regressions, which aim to explain bank risk. Our results suggest that moral hazard exists and that market discipline plays a role in mitigating banks' risk of insolvency.

Financial safety nets, bailouts and moral hazard

2010

The paper argues that policymakers bail out banks with financial problems to avoid the costs of financial repression. After financial liberalization and when risk is verifiable, in some circumstances policymakers can commit to policies that discipline banks ex-ante and ex-post, by providing bailout to conservative banks and threatening the takeover of risky banks. When these policies are time consistent, regulatory policies to deal with moral hazard ex-ante, like for example prudential regulation, become redundant and policymakers refrain from implementing them. JEL Classification: G01, G21, G28.

Risk management, corporate governance, and bank performance in the financial crisis

The recent financial crisis has raised several questions with respect to the corporate governance of financial institutions. This paper investigates whether risk management-related corporate governance mechanisms, such as for example the presence of a chief risk officer (CRO) in a bank's executive board and whether the CRO reports to the CEO or directly to the board of directors, are associated with a better bank performance during the financial crisis of 2007/2008. We measure bank performance by buy-and-hold returns and ROE and we control for standard corporate governance variables such as CEO ownership, board size, and board independence. Most importantly, our results indicate that banks, in which the CRO directly reports to the board of directors and not to the CEO (or other corporate entities), exhibit significantly higher (i.e., less negative) stock returns and ROE during the crisis. In contrast, standard corporate governance variables are mostly insignificantly or even negatively related to the banks' performance during the crisis. (M. Schmid). 1 There are also recent academic studies which emphasize that flaws in bank governance played an important role in the poor performance of banks during the financial crisis of (e.g., Diamond and Rajan, 2009. Also a recent OECD report concludes that the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements (Kirkpatrick, 2009). Moreover, argue that a strong and independent risk management is necessary to effectively manage risk in modern-day banks as deposit insurance protection and implicit too-big-to-fail guarantees weaken the incentives of debtholders to provide monitoring and impose market discipline. Moreover, the increasing complexity of banking institutions and the ease with which their risk profiles can be altered by traders and security desks makes it difficult for supervisors to regulate risks.