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FDIC Fall Workshop October 25, 2006 “Credibility of Non-Insurance and Governance as Determinants of Market Discipline and Risk-Taking in Banking”: Discussion Edward J. Kane Boston College Professors Angkinand and Wihlborg Investigate Two Questions:
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I. How do deposit-insurance coverage and corporate-governance variables affect the ability of market forces to “discipline” individual-bank risk taking?
II. How does a country’s macroeconomic environment affect the answer to question I?
Takeaway: Corporate-governance characteristics and deposit-insurance coverage interact differently in industrialized vs. emerging-market countries.
THE AUTHORS’ EMPIRICAL EVIDENCE ON THESE QUESTIONS COMES FROM WHAT EDWARD LEAMER WOULD CHARACTERIZE AS AN “HYPOTHESIS-TESTING SPECIFICATION SEARCH”
AUTHORS’ INTERPRETATION OF COEFFICIENT PATTERNS IS UNDERMINED BY AN INCOMPLETE AND SHIFTING IDEA OF THE GOAL THAT A BANK SUPERVISOR SHOULD PURSUE
In identifying relevant literature and in deriving testable hypotheses about the effects of deposit-insurance coverage, the discussion shifts back and forth unwisely between three incomplete and inconsistent goals for supervisory activity:
1) Controlling (sometimes even minimizing) bank risk taking. [This criterion neglects the potential social benefits of bank risk-taking];
2) Eliminating so-called “excessive” risk- taking [but “excessive” is not defined];
3) Minimizing the probability of a banking crisis [omits the projected costs of possible crises and the deadweight burdens that might be generated by the control instruments used].
Risk-shifting occurs whenever a contractual counterparty is exposed to loss from fraud, leverage or earnings volatility without being adequately compensated for the risk entailed.
Risk-shifting is subsidized whenever the value of the explicit and implicit deposit guarantees to a country’s banks exceeds the sum of the ex ante and ex post premia the insurer imposes on them.
IPP= γ0 + γ1σv + γ 2(B/V) + ε1, (1)
B/V = a0 + a1sV + e2, (2)
This structural model has the reduced form:
IPP = b0 + b1sV + e3. (3)
Ideal coefficient signs are α1< 0 and β1 < 0.
1. By expanding this specification, Hovakimian, Laeven, and I show that: Cross-country variation in the extent of safety-net subsidies is explained by variation in:
High IPP Supervisory Regimes Typically Subsidize Risk-Taking. High-Subsidy Countries Invite Crisis.