Depositors’ response to deposit insurance reforms:

Evidence from Japan, 1990-2005

Masaru KonishiHitotsubashi University

andIkuko Fueda

Japan Center for Economic Research

Motivation

1. Do depositors play a disciplinary role on riskier banks by requiring higher interest rates or/and by withdrawing their funds?

2. Do fully insured and partly uninsured depositors respond to bank risk differently?

3. Does a rapid withdrawal of deposits from risky banks force the bank’s manager to aggressively restructure bank management?

Method

Using data from Japanese banks during the 1990 to 2005 period, we empirically investigate

(1) how depositors respond to various measures for bank financial conditions, and

(2) how the management of risky banks respond to various disciplinary devises: depositor, shareholder, and regulatory discipline.

Major Results

1. Depositor discipline by deposit withdrawal was most significant during the period of full insurance coverage rather than during the period of limited insurance coverage.

2. There is little evidence of depositor discipline by requiring higher interest rates on riskier banks.

3. Deposit withdrawal induces bank managers to carry out aggressive restructuring.

Brief review of the related studies (1): Market discipline

• Interest rates on large CDs: Hannan and Hanweck (1988), Ellis and Flannery (1992), Brewer and Mondschean (1994), Cook and Spellman (1994)

• Risk premium of subordinated debts: Flannery and Soresue (1996), Evanoff and Wall (2001), Morgan and Stiroh (2001)

• No evidence of an effect of bank risk on the risk premium of subordinated debt: Avery et al. (1988), Gorton and Santomero (1990)

Brief review of the related studies (2): Depositor response to bank risk

• Depositor discipline by withdrawing deposits and requiring higher interest rates: – U.S. evidence: Park (1995), Park and Peristiani (1998)– Int’l evidence: Martinez-Peria and Schmukler (2001)

(Argentina, Chile, and Mexico) • Depositor discipline by withdrawing deposits:

– U.S. evidence from failing S&Ls: Goldberg and Hudgins (1996, 2002), Maechler and McDill (2006)

– Japanese evidence: Hosono (2003)• Depositor discipline by requiring higher interest rates

– Cross-country evidence: Demirguc-Kunt and Huizinga (2004)

• No evidence of depositor discipline– Gilbert and Vaughan (2001)

Contributions

1. Examine depositor discipline in a financial system different from the U.S.

2. During the 1990-2005 period, the Japanese financial system experienced a series of changes in deposit insurance regimes:

– The adoption of unlimited protection of all deposits in 1995

– The reinstatement of a 10 million yen deposit insurance cap on time deposits in 2002

– The reinstatement of a 10 million yen deposit insurance cap on demand deposits in 2005

3. Examine not only the necessary condition but also a sufficient condition for the existence of depositor discipline.

Chronology of deposit insurance reforms in Japan

1971: Japan established a deposit insurance system.1974: The insurance coverage was increased from 1 mil. yen to 3

mil. yen.1984: The insurance coverage was increased to 10 mil. yen.June 1995: The gov’t declared full protection for all deposits until

March 2001.Dec. 1999: The gov’t postponed the reinstatement of the insurance

cap for one year for time deposits (now April 2002) and two years for demand deposits (now April 2003).

April 2002: Reinstatement of the insurance cap for time deposits only.

Oct. 2002: The gov’t postponed full implementation of the insurance cap by two years (now April 2005).

April 2005: The insurance cap was finally set to be fully implemented!

Hypotheses

Hypothesis 1: Depositors seek to discipline risky banks by withdrawing their deposits.

Hypothesis 2: Depositors require higher interest rates on deposits at riskier banks.

Hypothesis 3: Uninsured depositors are more responsive to bank financial conditions than insured depositors are.

Hypothesis 4: The deposit withdrawal induces bank managers to engage in restructuring of banking operations.

Sample selection and data

• Unbalanced panel data of Japanese banks (city banks, regional banks, tier-two regional banks, credit associations, and credit cooperatives) covering the period from 1990 to 2005.

　　 Data source: Nikkei Financial Quest database, Annual Financial Statements of credit associations and credit cooperatives

• Our sample consists of 5,436 bank-year observations.

To conclude that depositor discipline is present, we need to show:

1. The growth of deposits is negatively and interest rates are positively associated with bank risk, or

2. The growth of deposits is negatively associated with bank risk but the interest rates are not related to bank risk, or

3. Interest rates are positively associated with bank risk but the growth of deposits is not associated with bank risk

Method (1): Test of depositor discipline via deposit withdrawal from riskier banks

DEPOSIT: growth rate of total, demand, and time depositsCAPITAL: capital ratioBADLOAN: the ratio of nonperforming loans to total assetsROA: the ratio of net business profits to total assetsCASH: the ratio of liquid assets to total assetsASSET: natural log of total assets(Both fixed effects and time effects are controlled.)

titititi

titititi

ASSETCASH

ROABADLOANCAPITALDEPOSIT

,1,51,4

1,31,21,1,

Method (2): Test of depositor discipline by demanding higher interest rates on riskier

banks

INTERESTRATE: interest payments by a bank on its deposits at the end of year t divided by the total amount of deposits averaged between beginning and the end of the year t.

titititi

titititi

ASSETCASH

ROABADLOANCAPITALTEINTERESTRA

,1,51,4

1,31,21,1,

Test periods

1. 1990-1994: 10 million insurance caps for both demand and time deposits; a period of forbearance policy

① 1990-1992

② 1993-1994

2. 1995-2001: Full protection for all kinds of deposits① 1995-1996

② 1997-2001: A period of financial crisis

③ 2001: The year preceding the partial reinstatement of insurance cap on time deposits

3. 2002-2004: Full protection for demand deposits, but not for time deposits

4. 2005: 10 million insurance caps for both demand and time deposits

Figure 1 Proportion of demand and time deposits for households and firms from April 1999 to April 2006

0

10

20

30

40

50

60

1999.04 2000.04 2001.04 2002.04 2003.04 2004.04 2005.04 2006.04

Demand deposit (firms) Demand deposit (households)

Time deposit (firms) Time deposit (households)

％

Method (3): Test of the importance of deposit withdrawal as a means of enforcing bank

restructuring

• RESTR: the rate of change in operating expense, personnel expense, nonpersonnel expense, number of employees and number of branches

• DEPOSIT: deposit growth ← depositor discipline• LISTED: a dummy variable that equals 1 if a bank is

publicly traded ← shareholder discipline• BISGAP: a bank’s capital ratio minus the regulatory

required ratio ← regulatory discipline• PUBLIC: a dummy variable that equals 1 if a bank was

recapitalized under Early Strengthening Law

titi

titititi

PUBLIC

BISGAPLISTEDDEPOSITRESTR

,1,

1,41,31,21,

（1） （2） （3） （4） 5（ ） （6） 7（ ）1990-1992 1993-1994 1995-1996 1997-2001 2002-2004 2005 2001

Variable Coefficeient Coefficeient Coefficient Coefficeient Coefficeient Coefficeient Coefficeient

Panel A: Total deposits regression

CAPITAL -0.08 -0.59 2.06 0.44 0.35 -0.04 0.33(-0.11) (-0.64) (2.92) *** (9.14) *** (2.39) ** (-0.54) (5.03) ***

BADLOAN -1.89 -3.30 -0.26 -0.28 -0.24 -0.01 -0.37(-0.28) (-2.90) *** (-1.34) (-9.65) *** (-3.52) *** (-0.15) (-7.07) ***

ROA -10.69 3.28 0.11 0.05 0.11 1.29 3.52(-2.23) ** (0.99) (0.07) (2.85) *** (0.36) (0.97) (4.21) ***

CASH 0.86 -0.14 -0.04 -0.12 -0.02 -0.04 0.09(3.92) *** (-0.60) (-0.25) (-3.76) *** (-0.52) (-0.84) (2.13) **

ASSET -115.25 -65.49 -54.89 -5.15 -42.17 -0.09 0.83(-13.46) *** (-5.55) *** (-4.48) *** (-3.07) *** (-13.25) *** (-0.27) (3.64) ***

Adjusted R2 0.60 0.35 0.40 0.45 0.78 0.00 0.31

Panel B: Demand deposits regression

CAPITAL -1.14 -2.83 1.92 -0.97 -1.02 0.02 -0.31(-1.25) (-1.21) (0.91) (-5.93) *** (-1.78) * (0.34) (-0.99)

BADLOAN -10.98 -1.48 -1.32 -0.13 -0.27 0.04 0.09(-1.34) (-0.51) (-2.22) ** (-1.27) (-1.01) (0.58) (0.34)

ROA 0.85 10.34 2.86 0.08 -0.76 -1.31 5.07(0.14) (1.21) (-0.57) (1.47) (-0.62) (-1.12) (1.27)

CASH 0.62 0.02 0.41 -0.38 0.20 0.00 -0.26(2.31) * (0.03) (-0.93) (-3.37) *** (1.13) (0.06) (-1.34)

ASSET -50.91 -113.53 -106.59 56.92 -49.19 0.50 -0.36(-4.84) *** (-3.73) *** (-2.89) *** (9.91) *** (-3.97) *** (1.85) * (-0.33)

Adjusted R2 0.23 0.03 0.32 0.39 0.18 0.00 0.00

Obsevations 239 253 562 3,204 1,677 541 619

Table 3The results of deposits and interest rate regression

（1） （2） （3） （4） 5（ ） 6（ ） 7（ ）1990-1992 1993-1994 1995-1996 1997-2001 2002-2004 2005 2001

Variable Coefficeient Coefficeient Coefficient Coefficeient Coefficeient Coefficeient Coefficeient

Panel C: Time deposits regression

CAPITAL -1.49 -0.71 1.99 0.60 0.82 -0.10 0.39(-1.04) (-0.05) (2.08) ** (11.23) *** (4.71) *** (-0.28) (5.26) ***

BADLOAN 37.05 -2.70 0.15 -0.22 -0.34 -0.29 -0.41(1.86) * (-1.97) ** (0.55) (-6.89) *** (-4.10) *** (-0.94) (-7.01) ***

ROA -13.18 2.51 3.70 0.04 -0.02 -2.22 4.73(-1.40) (0.63) (1.64) (2.11) ** (-0.05) (-0.40) (5.07) ***

CASH 0.97 0.57 -0.40 -0.09 -0.06 0.10 0.11(2.24) ** (2.07) ** (-2.03) ** (-2.38) ** (-1.10) (0.49) (2.43) **

ASSET -180.18 -37.34 -47.24 -4.68 -48.64 -1.25 -0.68(-11.74) *** (-2.62) *** (-2.86) *** (-2.51) ** (-12.85) *** (-0.96) (-2.67) ***

Adjusted R2 0.60 0.23 0.35 0.55 0.73 0.00 0.31

Obsevations 239 253 562 3,204 1,677 541 619

Panel D: Interest rate regression

CAPITAL 0.00 0.08 -0.02 0.01 -0.16 -0.05 0.00(-0.07) (1.52) (-0.99) (0.97) (-0.68) (-2.27) ** (-1.64)

BADLOAN 0.95 -0.03 0.01 0.00 -0.25 0.00 0.00(1.34) (-0.39) (-0.90) (0.95) (-2.36) ** (0.04) (1.11)

ROA -0.76 0.12 -0.04 -0.09 0.42 1.09 0.02(-2.29) ** (-0.60) (-0.77) (-1.51) (0.82) (3.22) *** (1.41)

CASH 0.07 0.03 0.00 0.00 0.02 0.01 0.00(4.44) *** (2.46) ** (-0.60) (-0.28) (0.25) (0.63) (-3.73) ***

ASSET -2.42 -2.95 0.72 0.13 -0.06 -0.10 -0.01(-4.45) *** (-4.28) *** (1.91) * (0.43) (-0.01) (-1.21) (-3.02) ***

Adjusted R2 0.83 0.90 0.98 0.44 -0.06 0.02 0.04

Obsevations 239 253 552 2,861 1,583 500 536

Table 3 (continued)

（1） （2） （3） （4） （5）Operating expense Personnel expense Nonpersonnel expense Number of Employees Number of branches

Variable Coefficeient Coefficeient Coefficeient Coefficeient Coefficeient

DEPOSIT 0.24 0.26 0.32 0.10 0.06(6.97) *** (7.73) *** (1.53) (2.83) *** (1.98) **

LISTED 0.07 0.06 -0.78 -0.91 0.07(0.17) (0.14) (-0.29) (-2.06) ** (0.19)

BISGAP 0.09 0.10 0.25 0.16 0.17(2.87) *** (3.37) *** (1.34) (5.10) *** (6.04) ***

PUBLIC -1.16 -2.15 0.45 -2.73 -2.09(-1.18) (-2.18) ** (0.08) (-2.73) *** (-2.35) **

Adjusted R2 0.03 0.04 0.00 0.03 0.02

Observations 2,392 2,392 2,392 2,392 2,392

Table 4The determinants of bank restructuring

Summary of the results

1. Depositor discipline by deposit withdrawal was most significant during the period of full insurance coverage rather than during the period of limited insurance coverage.

2. There is little evidence of depositor discipline by requiring higher interest rates on riskier banks.

3. Deposit withdrawal induces bank managers to carry out aggressive restructuring.

Why was depositor discipline most significant during the period of full protection?

1. Depositors were very cautious about bank risk because of the collapse of a few major banks in 1997 and 1998.

2. The Prime Minister announced in July 2002 that settlement-only accounts would be fully protected even after the full reinstatement of the deposit insurance cap.

3. Depositors might have taken protective measures, such as spreading their deposits over several banks, before the removal of full protection for demand

deposits in April 2005.