Comments on “Bank Risk and Comments on “Bank Risk and Regulatory Implications”Regulatory Implications”

Lawrence J. WhiteStern School of BusinessNew York Universitylwhite@stern.nyu.edu

Presentation at the Asia-Link Research Conference on “Safety and Efficiency of the Financial System,” Manila, 27th August 2007

OverviewOverview

IntroductionPaper I: “The Efficiency of Banks…”Paper II: “The Regulation of Financial

Conglomerates…”Paper III: “Does Uncertainty Matter…?”Some additional commentsConclusion

IntroductionIntroduction

Finance is importantFinance is specialBanks are importantBanks are specialSafety and efficiency of banks are

important and important to understand

““The Efficiency of Banks…”: The Efficiency of Banks…”: What they didWhat they did1st 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 efficiency2nd stage: OLS regressions to explain

average relative bank efficiencies, based on bank and country characteristics

““The Efficiency of Banks…”: The Efficiency of Banks…”: What they found (1)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

““The Efficiency of Banks…”: The Efficiency of Banks…”: What they found (2)What they found (2)2nd stage results

– A bank’s size, riskiness, and widely held ownership are positively related to technical efficiency

– A country’s real GDP growth and exchange rate variability are positively related to technical efficiency

– Allocative efficiency and cost efficiency are difficult to explain

““The Efficiency of Banks…”: The Efficiency of Banks…”: Some cautionsSome cautionsOutput measures neglect fee-based

activitiesInput measures are expenditures, not

physical inputsPrices of inputs are murkyDoes 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!

““The Efficiency of Banks…”: The Efficiency of Banks…”: Some suggestionsSome suggestionsMore descriptive statistics for 2nd stageAre 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?

““The Regulation of The Regulation of Financial…”: The purposeFinancial…”: The purposeExplain/describe financial conglomeratesReview international regulatory practice

and recommendationsReview existing Philippine regulationsOffer recommendations

““The Regulation of The Regulation of Financial…”: The findingsFinancial…”: The findingsFinancial conglomerates are a potential

problemInternational bodies recommend more

information, more coordinationPhilippines regulation is based on

specialties: BSP (and PDIC); SEC; ICPhilippines regulation needs more

recognition of the conglomerate phenomenon, more information sharing, more coordination

““The Regulation of Financial…”: The Regulation of Financial…”: Some cautions and suggestionsSome cautions and suggestionsExplain the distinctions among different

goals and types of financial regulation– Prudential regulation vs. consumer fraud

protection vs. information revelationWhat 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?

““Does Uncertainty Matter…?”:Does Uncertainty Matter…?”:What they didWhat they didDevelop 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.

““Does Uncertainty Matter…?”: Does Uncertainty Matter…?”: What they foundWhat they foundBanks 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

““Does Uncertainty Matter…?”: Does Uncertainty Matter…?”: Some cautionsSome cautionsSelection 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?

““Does Uncertainty Matter…?”: Does Uncertainty Matter…?”: Some suggestionsSome suggestionsMore intuition as to implications of

improved loan recovery likelihoodTry scaling charge-offs by NPLs or by

loan loss provisionsF-test on big bank/small bank comparison

and include bank size in both regressionsDirect fixed effects might reveal

something about individual banks or individual countries

“Uncertainty management”? or “Managing in response to uncertainty”?– Revenue smoothing? Profit smoothing?

Some additional commentsSome 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

Bank accounting 101 (A)Bank accounting 101 (A)

Healthy, solvent bank:

Assets Liabilities100 92

8

(based on market values, of course)

Bank accounting 101 (B)Bank accounting 101 (B)

Unhealthy, insolvent bank:

Assets Liabilities 80 92

-12

(based on market values, of course)

Banks are special (1)Banks are special (1)Banks are opaqueBanks 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

Banks are special (2)Banks are special (2)Banks may fail because of mismanagement

– Bad loans and investments may cause insolvencyBanks may fail because of depositor runs

– Imperfectly informed depositors, fearing insolvency, want to withdraw their funds quickly

ContagionCascades

Bank closures have costs for their customers– Depositors/creditors lose their funds– Borrowers need to find other lenders

The response to specialnessThe 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

Appropriate activities for a bankAppropriate activities for a bankActivities that are “examinable and supervisable”

– Regulators can set appropriate capital requirements– Regulators can assess the competency of the

management of the activityWhy should bank regulators prohibit banks from

undertaking activities that are examinable and supervisable?

What specifically are appropriate activities?

– Dependent on regulatory competence– Loans…– But Litan’s (1987) “narrow bank”?

Inappropriate activities for a bankInappropriate activities for a bankActivities that are not examinable and

supervisable– Regulators cannot set appropriate capital

requirements– Regulators cannot assess the competency of the

management of the activityHow 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…

What about the bank’s owners?What about the bank’s owners?

Bank owners can be individuals or a holding company

Owners – whether individuals or a holding company -- may drain a bank’s assets, to their benefit and to the detriment of depositors– Declare dividends to themselves– Self-dealing

Make loans to themselves that are not repaidSell stuff to the bank at excessively high pricesFavor their friends (with loans, etc.)

What are appropriate activities What are appropriate activities for the bank’s owners?for the bank’s owners?

Anything that is otherwise legal; butAll 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 arm’s-length terms

This logic applies regardless of whether the owners are individuals or a holding company– The current U.S. distinction that it’s OK for a local

retailer to own a bank but not OK for Wal-Mart to own a bank makes no economic sense

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

Owners(Other activities)

Holding company(Other activities)

Bank(examinable and

supervisableactivities)

Bank subsidiary(other activities)

Holding companySubsidiary

(other activities)

Implications for financial Implications for financial regulationregulationThink “examinable and supervisable” for

what can occur inside a bank (or insurance company, or pension fund)

Arm’s 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”

ConclusionConclusion

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