Comments on Bank Risk and Regulatory Implications

1
Comments on Bank Risk and Regulatory
Implications

• Lawrence J. White
• Stern School of Business
• New York University
• lwhite_at_stern.nyu.edu
• Presentation at the Asia-Link Research Conference
  on Safety and Efficiency of the Financial
  System, Manila, 27th August 2007

2
Overview

• Introduction
• Paper I The Efficiency of Banks
• Paper II The Regulation of Financial
  Conglomerates
• Paper III Does Uncertainty Matter?
• Some additional comments
• Conclusion

3
Introduction

• Finance is important
• Finance is special
• Banks are important
• Banks are special
• Safety and efficiency of banks are important and
  important to understand

4
The Efficiency of Banks What they did

• 1st stage DEA analysis of 80 banks, 6 Asian
  countries, 1999-2004
• 3 outputs loans, securities, other assets
• 3 inputs personnel expense, interest expense,
  other operating expenses
• 358 observations
• Compute technical efficiency, allocative
  efficiency, cost efficiency
• 2nd stage OLS regressions to explain average
  relative bank efficiencies, based on bank and
  country characteristics

5
The Efficiency of Banks What they found (1)

• 1st stage results (technical efficiency)
• Korea 0.9185
• Malaysia 0.8240
• Thailand 0.8063
• Hong Kong 0.7749
• Indonesia 0.7143
• Philippines 0.5880
• 49 observations with CRS 220 observations with
  IRS 89 observations with DRS

6
The Efficiency of Banks What they found (2)

• 2nd stage results
• A banks size, riskiness, and widely held
  ownership are positively related to technical
  efficiency
• A countrys real GDP growth and exchange rate
  variability are positively related to technical
  efficiency
• Allocative efficiency and cost efficiency are
  difficult to explain

7
The Efficiency of Banks Some cautions

• Output measures neglect fee-based activities
• Input measures are expenditures, not physical
  inputs
• Prices of inputs are murky
• Does 1999 include remnants of the crisis?
• 2nd stage regressions have LHS variables that are
  estimates, with standard errors
• Potential for heteroskedasticity
• Read Saxonhouse, AER March 1977 It will change
  your life!

8
The Efficiency of Banks Some suggestions

• More descriptive statistics for 2nd stage
• Are IRS banks smaller? DRS banks bigger?
• Why not combine the bank characteristics and the
  country characteristics into a single 2nd stage
  regression?
• More commentary on the implications
• Are most banks too small? Why? Restrictive
  regulations?
• Why are riskier banks more efficient?

9
The Regulation of Financial The purpose

• Explain/describe financial conglomerates
• Review international regulatory practice and
  recommendations
• Review existing Philippine regulations
• Offer recommendations

10
The Regulation of Financial The findings

• Financial conglomerates are a potential problem
• International bodies recommend more information,
  more coordination
• Philippines regulation is based on specialties
  BSP (and PDIC) SEC IC
• Philippines regulation needs more recognition of
  the conglomerate phenomenon, more information
  sharing, more coordination

11
The Regulation of Financial Some cautions and
suggestions

• Explain the distinctions among different goals
  and types of financial regulation
• Prudential regulation vs. consumer fraud
  protection vs. information revelation
• What about defined-benefit pension funds?
• Discuss the pluses and minuses of centralized
  regulation (e.g., the U.K.s FSA) and
  decentralized regulation (the U.S., the
  Philippines)
• What about the importance of good accounting?

12
Does Uncertainty Matter?What they did

• Develop a real-options model of loan charge-offs
• Key parameters trend and uncertainty of
  collateral value, discount rate, likelihood of
  full loan recovery
• Test the model
• 243 banks, 7 European countries, 1992-2005, 552
  (506) observations
• Net charge-offs regressed against bank size,
  capital, trend and variability of collateral
  (real estate), real GDP growth, etc.

13
Does Uncertainty Matter? What they found

• Banks exercise discretion in charge-offs
• Bank size ()
• Real estate uncertainty (-)
• Real estate trend (-)
• Interest rates () (?)
• Real GDP growth ()
• Bank capital (0)
• Only big banks exercise discretion

14
Does Uncertainty Matter? Some cautions

• Selection bias in useable observations?
• Use a Heckman procedure?
• Are observations corrected for inflation?
• Use time dummy variables?
• Huge t-statistics when capital ratio (as RHS
  variable) is absent why?
• 46 fewer observations (and much lower
  t-statistics) when capital ratio is included why?

15
Does Uncertainty Matter? Some suggestions

• More intuition as to implications of improved
  loan recovery likelihood
• Try scaling charge-offs by NPLs or by loan loss
  provisions
• F-test on big bank/small bank comparison and
  include bank size in both regressions
• Direct fixed effects might reveal something about
  individual banks or individual countries
• Uncertainty management? or Managing in
  response to uncertainty?
• Revenue smoothing? Profit smoothing?

16
Some additional comments

• These comments apply primarily to bank regulation
  and issues of universal banking and financial
  conglomerates
• But they apply, as well, to insurance companies
  and defined-benefit pension funds

17
Bank accounting 101 (A)

• Healthy, solvent bank
• Assets Liabilities
• 100 92
• 8
• (based on market values, of course)

18
Bank accounting 101 (B)

• Unhealthy, insolvent bank
• Assets Liabilities
• 80 92
• -12
• (based on market values, of course)

19
Banks are special (1)

• Banks are opaque
• Banks are important for
• Lending to small- and medium-size enterprises
• Deposits
• The payments system
• Banks generic combination of longer maturity,
  less liquid assets and shorter maturity, more
  liquid liabilities make them susceptible to
  depositor runs

20
Banks are special (2)

• Banks may fail because of mismanagement
• Bad loans and investments may cause insolvency
• Banks may fail because of depositor runs
• Imperfectly informed depositors, fearing
  insolvency, want to withdraw their funds quickly
• Contagion
• Cascades
• Bank closures have costs for their customers
• Depositors/creditors lose their funds
• Borrowers need to find other lenders

21
The response to specialness

• Safety-and-soundness regulation of banks
• Capital regulation
• Activities restrictions
• Managerial competency requirements
• Examiners and supervisors
• Deposit insurance
• Protection for depositors against regulatory
  failure

22
Appropriate activities for a bank

• Activities that are examinable and supervisable
• Regulators can set appropriate capital
  requirements
• Regulators can assess the competency of the
  management of the activity
• Why should bank regulators prohibit banks from
  undertaking activities that are examinable and
  supervisable?
• What specifically are appropriate activities?
• Dependent on regulatory competence
• Loans
• But Litans (1987) narrow bank?

23
Inappropriate activities for a bank

• Activities that are not examinable and
  supervisable
• Regulators cannot set appropriate capital
  requirements
• Regulators cannot assess the competency of the
  management of the activity
• How could bank regulators allow banks to
  undertake activities that are not examinable and
  supervisable?
• What specifically are inappropriate activities?
• Suppose that XYZ Bank wants to own and operate a
  delicatessen

24
What about the banks owners?

• Bank owners can be individuals or a holding
  company
• Owners whether individuals or a holding company
  -- may drain a banks assets, to their benefit
  and to the detriment of depositors
• Declare dividends to themselves
• Self-dealing
• Make loans to themselves that are not repaid
• Sell stuff to the bank at excessively high prices
• Favor their friends (with loans, etc.)

25
What are appropriate activities for the banks
owners?

• Anything that is otherwise legal but
• All transactions and the financial relationships
  between the bank and its owners (and the owners
  friends, etc.) must be tightly monitored by bank
  regulators
• Everything must be on arms-length terms
• This logic applies regardless of whether the
  owners are individuals or a holding company
• The current U.S. distinction that its OK for a
  local retailer to own a bank but not OK for
  Wal-Mart to own a bank makes no economic sense

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• Locations of Appropriate Activities for a Bank
  and of Other Activities
• Lines of ownership Transactions to be
  closely monitored

Owners (Other activities)
Holding company (Other activities)
Bank (examinable and supervisable activities)
Holding company Subsidiary (other activities)
Bank subsidiary (other activities)
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Implications for financial regulation

• Think examinable and supervisable for what can
  occur inside a bank (or insurance company, or
  pension fund)
• Arms length terms for all transactions between a
  bank and its owners (and their friend) are vital
• Functional (specialty) regulation is OK but
• Specialty regulators must be able to reach across
  functional boundaries, follow the money

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Conclusion

• Safety and efficiency of the financial system,
  and especially of banks, are important and
  important to understand
• Better policies and better regulatory
  implementations could have substantial positive
  social value