Effect of External Support on Bank Default and Operating Risks: Does Country Strength Matter?

• Author: Chung‐Hua Shen,Yu‐Li Huang,Kun‐Li Lin
• DOI: http://doi.org/10.1111/ajfs.12222
• Published date: 01 August 2018
• Date: 01 August 2018

Effect of External Support on Bank Default

and Operating Risks: Does Country Strength

Matter?

Chung-Hua Shen

Institute of Banking and Money, Nanjing Audit University, China and Department of Finance and Banking,

Shih Chien University, Taiwan

Yu-Li Huang*

Department of Finance and Banking, Shih Chien University, Taiwan

Kun-Li Lin

Department of Finance, Feng Chia University, Taiwan

Received 26 September 2016; Accepted 24 February 2018

Abstract

This study investigates how two forms of external support, namely, government and foreign

ownership, affect bank default and operating risks. The results show, first, that government

ownership reduces default risk and increases operating risk, while foreign ownership reduces

both default and operating risks. Second, government ownership decreases default risk espe-

cially for banks from advanced countries and countries with better national governance.

Third, foreign ownership from countries with better sovereign ratings decreases both default

and operating risks. Our results suggest that Asian countries should increase income or

national governance for more effective government support and open the domestic bank

market.

Keywords Default risk; Operating risk; Individual rating; Issuer rating; Government owner-

ship; Foreign ownership

JEL Classification: G15, G21

1. Introduction

Credit ratings occupy a key position in today’s financial markets, where high-qual-

ity, widely recognized ratings are fundamental for the proper functioning of finan-

cial markets. Owing to their opaqueness, credit ratings are especially crucial for

banks. Credit rating agencies typically assign two types of ratings to a bank, namely,

*Corresponding author: Department of Finance and Banking, Shih Chien University, No. 70,

Dazhi St, Taipei 104, Taiwan. Tel: +886-2-2538-1111, Fax: +886-2-2533-6293, email:

ylhuang@g2.usc.edu.tw.

Asia-Pacific Journal of Financial Studies (2018) 47, 501–528 doi:10.1111/ajfs.12222

©2018 Korean Securities Association 501

individual and issuer ratings. An individual rating reflects the intrinsic financial

strength of an institution based on the assumption that no external support is

forthcoming, whereas an issuer rating indicates the likelihood and magnitude of the

issuer’s capacity to repay its debt obligations and considers the external support

that banks may receive. Prior literature has used issuer ratings to proxy default risk

(Iannotta et al., 2013; Shen and Huang, 2013; Huang and Shen, 2015) and individ-

ual ratings to proxy operating risk (Iannotta et al., 2013). Default risk is the proba-

bility that a bank’s creditors suffer losses as a consequence of a delay in interest or

principal payment, debt restructuring, or bankruptcy. Operating risk is the proba-

bility that a bank’s asset value decreases below the value of its liabilities, thereby

leading to negative equity capital (Iannotta et al., 2013). The difference between

these two ratings is referred to as “external support,” which represents extra influ-

ence on individual ratings affected by outside factors, such as government or for-

eign parent companies. Whether the external factors can improve or aggravate bank

risk is an interesting empirical issue.

This study has two goals. First, we investigate how rating agencies assess the

effects of two forms of external support, namely, government and foreign

ownership, on issuer and individual ratings. We refer to the investigation as the

benchmark model. Second, we examine whether country strength influences the

effects of two forms of external support, namely, government and foreign owner-

ship, on default and operating risks. We refer to the examination as the extended

model.

For the first goal related to government ownership, prior literature has mainly

focused on whether excessive government interference adversely affects bank operat-

ing risk. Although one theory suggests that government ownership may reduce

operating risk by internalizing potential bailout costs (Iannotta et al., 2013), large

government ownership is commonly found to be less efficient than private owner-

ship, thereby diminishing bank value (Barth et al., 2000; La Porta et al., 2002).

After the 2008 subprime crisis, the negative pre-crisis attitude toward governments

improved. Governments bailed out many large banks, preventing them from

defaulting. Studies have focused on either the higher operating risk (Iannotta et al.,

2007, 2013) or the lower default risk of government-owned banks (Brown and

Dinc

ß, 2011; Iannotta et al., 2013). An exception is Iannotta et al. (2013), who

examine the effects of government ownership on two risks jointly. They use credit

rating data from large banks in 16 advanced European countries and find that gov-

ernment-owned banks have a lower default risk but a higher operating risk than

private banks. We also examine the effects of government-owned banks’ default and

operating risks jointly; however, we use banks from Asian countries to examine the

robustness of Iannotta et al. (2013) results. We explain other reasons for using

Asian countries shortly.

Unlike the influence of government ownership on the two risks, which are to a

greater extent certain, the effects of the external support of foreign ownership on

the two risks are less conclusive. The literature focusing on the effects of foreign

C.-H. Shen et al.

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