Resolution of Failed Banks by Deposit Insurers Cross-Country Evidence
| Author | Thorsten Beck; Luc Laeven |
| Profession | World Bank and CEPR |
| Pages | WPS3920 |
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Beck is at the World Bank and Laeven is at the World Bank and CEPR. Corresponding author: Thorsten Beck, World Bank, TBeck@worldbank.org, Phone: (202) 473-3215, Fax: (202) 522-1155. We would like to thank Asli Demirguc-Kunt and Ross Levine for very useful comments and Baybars Karacaovali for excellent research assistance.
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There is a broad variation in countries? framework and practice to resolve failing banks.
Some countries rely on the court system to declare banks insolvent and to resolve them. Other countries have delegated the power to resolve failing banks almost completely to bank supervisors with little if any judicial recourse (see Hpkes, 2004, and Beck, 2004, for a discussion of differences in bank failure resolution schemes across countries). There is also variation in the degree to which bank failure resolution interacts with deposit insurance, which is another increasingly popular component of the financial safety net. In some countries, such as Brazil, the deposit insurer is set up as a paybox with the function to pay out depositors of failed banks, while in other countries, such as the United States, the deposit insurer not only has important supervisory functions, but has the lead role in resolving failing banks.
Resolving weak banks efficiently can have important repercussions for financial and economic development. Honohan and Klingebiel (2003) estimate the average fiscal cost of banking crisis resolution at 13% of GDP, while Claessens, Klingebiel and Laeven (2003) show that different approaches to resolving banking crises have led to very different outcomes in terms of recovery of economic growth after the crisis. But even the failure of individual banks can imply large financial and economic costs for depositors, borrowers and taxpayers, as the failure of institutions such as the Bank of Credit and Commerce International (BCCI) has shown (see Bartholomew and Gup, 1997, for an overview of bank failures across non-US G10 countries).
While there is a large theoretical and empirical literature on the insolvency and resolution of non-financial corporations, the literature on financial corporation distress has focused mostly on systemic banking crises, i.e. the determinants and resolution strategies for wide-spread bank Page 2 failures, rather than on the efficient resolution of idiosyncratic bank failures.1 Similarly, while there is a large theoretical and empirical literature on the relationship between deposit insurance and bank fragility, its link with bank failure resolution has not been empirically explored.2 While policy makers' attention has recently shifted to the non-systemic resolution of idiosyncratic bank failures, up to date there is no cross-country evidence on its optimal design.3 In this paper we assess empirically the relationship between the design of bank failure resolution arrangements and bank fragility. Specifically, this paper addresses two questions: First, is a bank failure resolution system that relies more on the deposit insurer more conducive to market discipline? Second, which institutional structure of a deposit insurer involved in bank failure resolution is most conducive to bank stability?
There is little disagreement that banks need special insolvency rules compared to non- financial corporations (Hpkes, 2004). Their role in transforming maturity, i.e. transforming short-term deposits into medium to long-term loans, makes banks more sensitive to short-term liquidity shortages that ultimately could result in bank runs (Diamond and Dybvig, 1983). Specifically, an interruption of the access to their savings in the failed bank can cause depositors to panic and run on other, fundamentally sound, banks. Furthermore, the information value of an ongoing credit relationship, which serves as the basis for debtor discipline and access to credit, decreases substantially in the case of failing banks. Finally, banks' critical role in market-based economies - providing payment services and intermediating society's savings - and their role in Page 3 the transmission of monetary policy may justify special insolvency rules for banks (Benston and Kaufman, 1996).
While the special nature of banking and its importance for market economies justifies a special regulatory, supervisory and insolvency regime, the rules for this regime have to be structured in an incentive-compatible way. Given the call-option character of bank equity, bankers face strong incentives to lend aggressively and take on excessive risks, ignoring prudent risk management (Merton, 1977). The lower their capital base, the less they have to lose and the more they can gain through aggressive lending. Both discipline by creditors and depositors and the regulatory and supervisory framework have an important role to play in checking these incentives. Similarly, the effective and timely intervention and resolution of failing banks is important to minimize aggressive risk taking by banks and thus reduce bank fragility. If bankers know that they face immediate exit combined with the immediate and complete loss of all equity in the case of insolvency, they are less willing to take aggressive risks. If depositors and creditors know that they will suffer losses in the case of bank failure, they will be more willing to exert market discipline. Effective and timely intervention and resolution of failing banks is thus crucial to maintain market discipline and reduce bank fragility. In practice, however, bank authorities are often slow to close banks, allowing for regulatory capital forbearance, particularly in the case of explicit deposit insurance and systemically important banks (see Ronn and Verma (1986) for a model of deposit insurance that incorporates regulatory forbearance). Empirical research shows that in particular during episodes of systemic financial crisis, bank authorities are often reluctant to close banks, resulting in large fiscal costs and a deeper crisis in terms of corporate sector slowdown (Honohan and Klingebiel, 2003, and Claessens, Klingebiel and Laeven, 2003).
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Theory, however, does not provide an unambiguous answer to the question of who should resolve failing banks. In countries with explicit deposit insurance schemes, deposit insurers might be more likely to carefully monitor banks and intervene rapidly into failing banks as they have to carry the costs in terms of higher pay-out to indemnified depositors. However, deposit insurers might also face perverse incentives. First, if the deposit insurance agency is run by the banking industry itself, it might face a conflict of interest in dealing with failing banks. Second, similar as bank supervisors, deposit insurers might have incentives to postpone realization of bank losses to avoid that bank failure "happens on their watch". Third, if the deposit insurer is placed with uninsured depositors in the creditor preference during bankruptcy and ahead of other non-deposit creditors, they might face incentives to intervene too late (Bliss and Kaufman, 2006).
The discussion on the role of the deposit insurance agency in bank failure resolution is also intimately linked to the design and structure of the deposit insurance scheme. On the one hand, the incentive-compatible structure of deposit insurance can be enhanced by a proper alignment of interests. Funding and administration of the deposit insurance scheme by the banking industry can increase the incentives of the deposit insurer to minimize insurance losses.
On the other hand, a deposit insurance scheme can only maintain market discipline and minimize moral hazard risks if problem banks are efficiently and timely intervened and resolved. Theory suggests that the possibilities of the deposit insurer to minimize insurance losses can be further enhanced by aligning interests such as by yielding supervisory power to the deposit insurer. This can be taken even further by giving the deposit insurer the authority and responsibility to intervene into problem banks and resolve failing banks.
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In this paper we study empirically the link between the involvement of deposit insurers in bank failure resolution and bank risk. In section 2, we present cross-country indicators of the responsibility of deposit insurers to intervene into banks across 57 countries. We also consider a second indicator, the power of deposit insurer to cancel or revoke the deposit insurance for one of their members. Further, we consider to which extent deposit insurers are independent from political pressure and have access to supervisory information and the interaction of these two institutional features with the role of deposit insurers in bank failure resolution. We enrich the data analysis with a discussion of some specific country cases to illustrate to which extent the institutional variation of deposit insurance and bank failure resolution varies across countries. In section 3, we turn to formal hypothesis testing. Specifically, we regress a measure of bank risk on the indicators introduced in section 2, controlling for other bank-and country traits. Our results indicate the importance of the deposit insurer?s role in maintaining bank stability. Banks are more stable, i.e. farther away from insolvency in countries where deposit insurers have a greater role in bank failure resolution. This empirical finding is robust to controlling for other bank and country characteristics, most importantly to controlling for the generosity of...
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