Abstract
The relationship between banks' capitalisations and risk-taking behaviours has important implications for regulatory policies. This empirical study incorporates the incentives of the three entities that influence the risk determination of a bank, namely regulatory agencies, shareholders, and management. The test results using data from the Korean banking system show measurable differences in risk–capitalisation relationships across banks differentiated by the level of capitalisation, and across publicly- and nonpublicly traded banks. These results provide evidence that risk–capitalisation relationships are sensitive to the relative forces of the three sources of influence in determining asset risk — which may account for previous inconclusive findings.
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References and Notes
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In studying the New England banking crisis, Peek and Rosengren3 find that one-third of the failed banks experienced a decline in their capital ratios in excess of five percentage points in a single quarter.
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Some risk measures used in literature include market measure of equity risk,20,21 standard deviation of asset returns,15,22,12 probability of failure,12,16,22,18 default risk implied by CD rates,23,14 and portfolio risk.11,24,25,13 See the second section for a more detailed discussion of this.
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Three different measures of equity risk are used in empirical studies. Total risk is the standard deviation of the bank's daily (weekly, monthly) returns. Systematic risk is the component of risk that is attributable to market-wide risk sources. Firm-specific risk is the risk that is unique to an individual bank.
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For instance, ‘the systematic risk of equity (βS) is greater than or equal to the systematic risk of the firm (βV) for βV>0’, Galai and Masulis,32 p. 59.
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Ronn and Verma35 give a detailed discussion of this issue.
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Examples of a more stringent capitalisation include the introduction of uniform capital standards during the first half of the 1980s in the United States and the implementation of the Basel Capital Accord of 1988.
Suppose that return on asset A is narrowly dispersed on the support [0, 10], and return on asset B is widely dispersed on the support [10, 100]. Obviously, asset B has greater standard deviation, but asset A is riskier (in the sense of first order stochastic dominance).
Default risk and credit risk are used interchangeably in the literature. However, ‘while default risk could refer to any failure to perform under the contract, credit risk is more specific, referring to a financial inability to pay’ (Smithson,39 p. 403). Default ‘should not be interpreted as bankruptcy, because creditors often forgive small shortfalls rather than bear larger bankruptcy costs or transfers to other creditors’ (Scott,40 p. 342).
Smithson, C. W. (1998) ‘Managing Financial Risk’, Mcgraw-Hill, New York.
Scott, J. (1981) ‘The probability of bankruptcy: A comparison of empirical predictions and theoretical models’, Journal of Banking and Finance, Vol. 5, pp. 317–344.
Altman and Saunders42 provide a nice summary on the evolution of the literature on default (credit) risk measures. They identify various kinds, such as (1) expert systems and subjective analysis, (2) accounting-based credit-scoring models, (3) risk-of-ruin models, (4) term structure derivation of probability of default, (5) capital market-based mortality rate models, and (6) neural network analysis.
Altman, E. I. and Saunders, A. (1998) ‘Credit risk measurement: Developments over the last, 20 years’, Journal of Banking and Finance, Vol. 21, pp. 1721–1742.
The variable Z should not be confused with Altman et al.'s44 Zeta score, which is also a probability of default measure and is obtained by combining and weighing key accounting variables. Altman et al.'s Zeta model, accounting-based credit-scoring model, is the best known and most commonly used.
Altman, E. I., Haldeman, R. G. and Narayanan, P. (1977) ‘ZETA analysis — A new model to identify bankruptcy risk of corporations’, Journal of Banking and Finance, Vol. 1, pp. 29–54.
Z is defined as (α−K/A−μROA)/σROA, where α is the ratio of overhead (taxes plus expenses on personnel, materials and office space) to total assets.
Theoretically, ‘the relationship between CD rates and the likelihood of insolvency can be expressed as (1+r)−t=(1−p)t(1+rf)t+[1−(1−p)t](1−l)(1+rf)−t, where r is the one-period CD yield, p is the conditional one-period probability of default (assumed to be constant over time), rf represents the risk-free rate, l is the expected loss per dollar of deposits in the event of default, and t is the number of periods until maturity’ (Hannan and Hanweck,23 p. 204).
The major loans made by US commercial bank lending activities can be segregated into four broad categories. These are real estate, C&I, individual, and others. C&I loans includes credit to construct business plants and equipment, loans for business operating expenses, and loans for other business uses. It is the second largest loan category in dollar volume among the loan portfolio of US commercial banks.
Samolyk, K. A. (1994) ‘US banking sector trends: Assessing disparities in industry performance’, Economic Review, (Federal Reserve Bank of Cleveland), Vol. 30, No. 2, pp. 2–17.
Avery, R. B. and Berger, A. N. (1991) ‘Risk-based capital and deposit insurance reform’, Journal of Banking and Finance, Vol. 15 (September), pp. 847–874.
Among the five dimensions of CAMEL ratings by regulatory authorities is included the quality of management.
For example, ‘banks whose overall CAMELS rating is toward the low, riskier end of the numerical scale — an overall rating of 4 or 5 — are examined more frequently than the highest-rated banks, those with ratings of 1, 2, or 3’ (Rose,52 p. 524).
Rose, P. S. (1999) ‘Commercial Bank Management’, Irwin McGraw-Hill, New York.
Jeitschko, T. D. and Jeung, S. D. (2007) ‘Bank capitalization and asset risk under managerial moral hazard’, Mimeo, Michigan State University.
One example is the FDIC. ‘According to the FDIC Improvement Act of 1991, a bank possessing a CAR ratio greater than five per cent would be considered well capitalized. A CAR ratio of four per cent or more would be considered adequate capitalization. A bank would be labeled undercapitalized if the ratio falls below four per cent’ (Rose,52 p. 484). Similarly, Korean regulatory authorities, the Financial Supervisory Service of Korea, use CAR as the key element in evaluating the capital adequacy of a bank.
Managers can control the capital-to-asset ratio in several ways, for example, by changing divided policy, issuing new stock, or selling off assets (ie securitisation).
‘Larger banks typically are wholesale lenders, concentrating on large-denomination loans to corporations and other business firms (C&I loans). Smaller banks, on the other hand, tend to emphasize retail credits, in the form of small denomination consumer loans, home mortgage loans, real estate and agriculture loans. It is known that C&I loans are riskier than the other category of loan’ (Rose,52 pp. 519–522).
Berger, P. G., Ofek, E. and Yermack, D. L. (1997) ‘Managerial entrenchment and capital structure decisions’, Journal of Finance, Vol. 52, pp. 1411–1438.
Demsetz, R. S., Saidenberg, M. R. and Strahan, P. E. (1997) ‘Agency problems and risk taking at banks’, Working paper, Federal Reserve Bank of New York.
Demorguc-Kunt, A., Laeven, L. and Levine, R. (2003) ‘The impact of bank regulations, concentrations, and institutions on bank margins’, Conference on Bank Concentration and Competition, World Bank, Washington, DC, 3rd–4th April, 2003.
Financial Supervisory Service (2006) Annual Report, Seoul, Korea.
Just prior to the financial crisis, due to financial liberalisation and the resulting restructuring of the financial sector, the number of nationwide commercial banks had increased from only five at the end of the 1970s to 16; regional commercial banks fared similarly.62
One exception is the case of the First Bank of Korea. This bank was in severe financial distress and sold to New Bridge in 1998. New Bridge took charge of the bank, implemented restructuring and sold it to another foreign institution, Standard Chartered in 2005.
There are two kinds of commercial banks in Korea: nationwide commercial banks and regional banks. The former ones are the major commercial banks of Korea that do business on a nationwide basis. The other banks are headquartered in specific regions and focus their business on that specific region and the capital city (Seoul). Both of these two types of commercial banks do business in a much wider geographical region than the mutual savings banks. As of the end of 2005, there are nine nationwide banks and six regional banks.
The fixed effects method assumes that the unobserved factors do not change over time. If one wants to allow unobserved factors to change over time, a random effects method must be used. One drawback of the random effects method, however, is that the unobserved factors must be assumed to be uncorrelated with the explanatory variables.65 Therefore, it is more appropriate to use fixed effects in this study. At any rate, we found that a random effects stipulation gives similar results as fixed effects.
Wooldridge, J. M. (2000) ‘Introductory Econometrics: A Modern Approach’, South-Western Publishing, Mason, Ohio.
The correlation between the RWA ratio and the NPL ratio is 0.47 for the commercial bank data set.
One standard deviation change of the NPL ratio will bring about only a 0.12 standard deviation change of the RWA ratio in regression (4).
Other studies, such as McManus and Rosen13 and Jeitschko and Jeung,69 however, suggested that a higher level of the critical value may be more appropriate for dividing high- and low-capital banks. Both the studies used 7 per cent as the criterion in studying the relationship between portfolio risk and capitalisation for banks in USA. The 7 per cent criterion is well above the regulatory minimum of 5 per cent which is the threshold for a bank to be classified as well capitalised by bank regulators of USA. In this study, however, it is difficult to follow McManus and Rosen13 or Jeitschko and Jeung.69 Korean banks are significantly undercapitalised compared to American banks. During the sample period, there are no commercial banks that have capital ratio over 7 per cent. For the mutual savings banks, the ratio of banks that has capital ratio exceeding 7 per cent is 38 per cent for the same period. Therefore it is unreasonable to use a criterion of 7 per cent for banks in Korea.
Jeitschko, T. D. and Jeung, S. D. (2004) ‘The effect of capitalization on bank's risk under regulation and managerial moral hazard — A theoretical and empirical investigation’, available at SSRN: http://ssrn.com/abstract=629414.
The positive relationship below the turnaround point is not as weak as it seems. Eighteen out of 332 savings banks have negative CAR up to minus 34 per cent for the sample period.
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We thank Christophe Godlewski and Tim Hannan for helpful comments and discussion.
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1 Thomas D. Jeitschko is Professor of Finance at Royal Holloway College, University of London, and Associate Professor of Economics at Michigan State University in East Lansing, Michigan. He holds additional appointments as adjunct Professor of Finance in the Finance Department and as adjunct Professor of Law in the Law School at Michigan State University. He specialises in economic theory and information economics with applications across several fields, including financial intermediation, banking, and law. He has published his research in the American Economic Review, Games and Economic Behavior, Economic Theory, and the Journal of Banking and Finance, among other places.
2 Shin Dong Jeung is the Head of the Early Warning Team in the Macro-Supervision Department of the Financial Supervisory Service — the Korean Banking Regulatory Agency — in Seoul. He holds a PhD in economics from Michigan State University and has previously worked for the Bank of Korea (the central bank of Korea). He specialises in risk-taking behaviour in banking and has carried out theoretical and empirical work across several countries, including the United States and South Korea. He has previously published in the Journal of Banking and Finance.
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Jeitschko, T., Jeung, S. Do well-capitalised banks take more risk? Evidence from the Korean banking system. J Bank Regul 8, 291–315 (2007). https://doi.org/10.1057/palgrave.jbr.2350054
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DOI: https://doi.org/10.1057/palgrave.jbr.2350054