RISK‐SHIFTING BEHAVIOR AT COMMERCIAL BANKS WITH DIFFERENT DEPOSIT INSURANCE ASSESSMENTS: FURTHER EVIDENCE FROM U.S. MARKETS

• DOI: http://doi.org/10.1111/jfir.12117
• Published date: 01 March 2017
• Author: Chuang‐Chang Chang,Ruey‐Jenn Ho
• Date: 01 March 2017

RISK-SHIFTING BEHAVIOR AT COMMERCIAL BANKS WITH DIFFERENT

DEPOSIT INSURANCE ASSESSMENTS: FURTHER EVIDENCE FROM

U.S. MARKETS

Chuang-Chang Chang

National Central University

Ruey-Jenn Ho

Providence University

Abstract

In this article, we investigate both the risk-shifting behavior of banks and the extent to

which risk was controlled after the Federal Deposit Insurance Corporation adopted a

risk-based assessment system in U.S. markets. The risk-shifting behavior of commercial

banks was significantly mitigated by the adoption of a risk-based deposit insurance

assessment system. The risk-shifting incentive remains, especially for less capitalized or

higher premium banks, which suggests that during 1992–2008, risk-based assessments

reduced but did not eliminate the moral hazard problem in banks. Moreover, the results

reveal that larger banks did not risk shift more than did smaller banks following the 1991

deposit insurance reform.

JEL Classification: G21, G28

I. Introduction

In the finance literature, the role of deposit insurance is a debatable issue. In general,

deposit insurance aims to protect depositors and prevent them from making unnecessary

withdrawals. Diamond and Dybvig (1983) show that deposit insurance protects financial

institutions from instability and enhances the stability of a financial system. However,

deposit insurance also provides financial institutions with incentives to increase risks

and, if deposit insurance premiums do not reflect those risks, to appropriately to shift

such risks to insurers.

When deposit insurance was introduced in the United States, the Federal Deposit

Insurance Corporation (FDIC) designed a fixed-rate system. Under such a flat-rate

assessment, most conjectures in the prior literature suggest that banks have incentives to

extract wealth from insurers (e.g., Mussa 1986; Kane 1987). Several studies show that

because the premiums within flat-rate deposit insurance assessments are not risk

adjusted, the systems encourage banks to take excessive risks (e.g., Merton 1977;

We are grateful to the editors, Richard Brown (associate editor), and an anonymous referee for their

constructive suggestions and comments. We also thank Professors Jing-Twen Chen, Keng-Yu Ho, Sharon Yang,

Jeffrey Wang, and the participates of 2011 KFA&TFA joint conference for providing many valuable suggestions

on the prior version. All errors or omissions within are solely those of the authors.

The Journal of Financial Research Vol. XL, No. 1 Pages 55–80 Spring 2017

55

© 2017 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

Pesando 1985). Therefore, a wealth transfer and moral hazard occurs when banks

intentionally increase their risk in flat-rate deposit insurance conditions. To ameliorate

this incentive to take risks, the U.S. Congress introduced the Federal Deposit Insurance

Corporation Improvement Act (FDICIA) of 1991; the FDIC implemented the risk-based

premium system in 1992. Since then, federal regulators have been able to monitor banks

in a risk-based assessment system. To the extent that deposit insurance premiums are not

correctly priced, though, it has not been clear whether the moral hazard is mitigated.

1

Existing empirical evidence on ri sk shifting at commercial banks is mi xed.

Several studies of this iss ue in the U.S. market have show n that insured banks took

excessive risks and shifted the ir risk to the FDIC. For example, Grossman (1992) finds

a positive relation between depos it insurance and bank risk taking in the U.S. ma rket.

Hovakimian and Kane (2000) find tha t the deposit insurance system did not

prevent U.S. banks from shift ing their risk onto the FDIC , especially in cases of banks

that were undercapitalized and had a higher deposit-to-debt ratio. Ev idence from other

countries also identifies poten tial risk-shifting problem s among banks. Wagster (20 07)

confirms that the adoption of e xplicit deposit insurance ex panded risk-shifting

incentives for Canadian bank s and trust companies. Ioannido u and Penas (2010) find

that Bolivia banks were more likely to initiate riskier loans during the post-deposit-

insurance period. Using an i nternational country sampl e, Demirg€

uSc-Kun t and

Detragiache (2002) and Hova kimian, Kane, and Laeven (20 03) find that deposit

insurance increased the risk-shifting probability, especially in countries with weak

financial environments, low levels of political and economic freedom, and high levels

of corruption.

However, several studies also offer contrasting evidence regarding risk-shifting

behavior. Flannery (1989) argues that existing regulatory practices, linking capital

adequacy to loan quality, could eliminate risk shifting. Duan, Moreau, and Sealey (1992)

suggest that risk shifting is not widespread in the U.S. market, with some exceptions.

Karels and McClatchey (1999) find that the adoption of deposit insurance in the 1970s

decreased the risk taking of U.S. credit unions.

In light of these conflicting results, it seems warranted to seek further evidence

regarding the effect of deposit insurance on the risk-shifting behavior of banks. In

particular, we compare the risk-shifting behavior of banks before and after the

introduction of the risk-based premium system in the U.S. market. We focus our tests on

deposit insurance reform for two reasons. First, study samples have covered the period of

deposit insurance reform, which contains a clear structured break and therefore may

cause a structured change in banks’risk-shifting behavior. Second, most empirical

results from previous studies focus on the risk-shifting behavior of banks during the

fixed-rate deposit insurance period in the U.S. market. We are more interested in

investigating risk-shifting behavior during the period of risk-based deposit insurance and

1

For example, in the early 2000s, the designated reserve ratio restricted the FDIC from charging premiums to

well-capitalized and highly rated banks as long as the insurance fund reserves were above 1.25% of insured

deposits. As a result, more than 90% of all insured banks did not pay deposit insurance premiums in the early 2000s,

and therefore, the system did not effectively price risk.

56 The Journal of Financial Research