When good intentions go wrong: Effects of bank deregulation and governance on risk taking

Manuel Illueca, Lars Norden, Gregory F Udell, 26 June 2013

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The motivation of economic liberalisation is to foster competition in order to increase allocative efficiency, economic growth and social welfare. This paradigm hinges on the assumption that firms maximise value and that more competitors in a market automatically leads to more competition.

However, this view does not take into account the link between regulation and corporate governance, and its influence on firms’ behaviour. When regulatory constraints are removed, the outcome may critically depend on the interaction between corporate governance and firm behaviour, particularly if behaviour is not primarily driven by value maximisation and if the regulatory constraints had been designed to inhibit risk taking.

Geographic deregulation of the cajas: ‘The Spanish experience’

In a recent study (2013), we investigate the effects of the interplay between deregulation and governance on risk taking in the financial industry. We analyse a large-scale natural experiment in banking deregulation in Spain: the 1988 removal of branching barriers on the Spanish savings banks, also known as the ‘caja’ banks. We extend and complement the cross-sectional evidence on the link between bank regulation, governance and risk taking provided by Laeven and Levine (2009).

Our analysis is based on a unique dataset that combines information on the geographic distribution of bank branches, matched lender-borrower financial statements, bank-governance characteristics, and borrower defaults.

Figure 1. Evolution of bank lending by bank type and lending segment

Note: Figure 1 displays the evolution of the lending volume to construction and real estate firms (RE + C) and other firms (Other) by the deregulated savings banks (SB) and the private commercial banks (CB). The caja banks increased their lending significantly since 1988 in comparison to the private commercial banks. The effect is even stronger for lending to real estate and construction firms.

What is special about government-owned banks?

Government-owned banks represent about 40% of the world’s banking industry (La Porta, Lopez-de-Silanes and Shleifer 2002). Exploring state ownership of banks is important because the nature of a ‘large owner’ is fundamentally different in government-owned or -controlled banks than private banks for at least three reasons:

  • First, governments-as-owners may deviate significantly from value maximisation.

They often pursue social welfare objectives such as economic development, cultural goals, overcoming market failure, and offering financial services to disadvantaged groups. These alternative objectives can have negative effects, such as underperformance and inefficient credit allocation because of political influence, agency problems, fraud and corruption.

  • Second, there is no market for corporate control for government-owned banks.

Control is ‘sticky’ in the sense that it cannot be easily transferred to another party, which makes these banks vulnerable to government influence and political rent seeking. However, there is one special mechanism that can facilitate a transfer of control of a government-owned bank: politicians can change after an election.

  • Third, state-owned banks might be subject to influence from local, regional or federal politicians.

A shift from local to regional or federal control – which actually happened at the Spanish cajas in the 1990s – could facilitate empire building and non-value maximising career and promotion behaviour. Furthermore, regional or federal control may lead to increased political influence because of the higher coordination of the voting rights allocated to politicians.

Main results

We find that the geographic expansion of the Spanish savings banks is associated with a significant increase in ex-ante risk taking and ex-post default risk. The cajas lent to firms in new markets that were ex ante more risky than the borrowers in their home markets and than those of privately owned commercial banks. We further document that these firms were more likely to file for bankruptcy. These results are established in an analysis that controls for observable firm, bank, province, and time effects and deals with different forms of unobserved heterogeneity. The increase in risk taking becomes substantially stronger for cajas in which regional governments have a stake in the board of directors, for an expansion to regions that are ruled by the same political party as the home region of the bank, and for the lending to firms in the real estate and construction industry. In several additional empirical tests we rule out alternative explanations for our results (e.g., alternative expansion motives, market entry cost effects, competition effects, and offsetting risk with stricter loan terms) and confirm the robustness of our main findings.

The results show that liberalisation led to a differential in risk taking in the Spanish banking system that was related to the governance problems in the savings-bank industry. Good intentions went wrong! Nearly all of the cajas failed and were reorganised as commercial banks with a radically different governance structure and different type of government involvement, as stated in the Memorandum of Understanding signed by Spain and the EFSF in 2012.

Parallels and policy implications

The story of the cajas is compelling because of its spectacular size and because the future of the euro will depend in part on how Spain weathers the crisis. It is also relevant for other countries, most of which also have savings banks and/or their cousins, co-operative banks. Many countries have liberalised the regulatory constraints on components of their banking systems often with negative consequences. For example, Germany abolished state guarantees for its Landesbanks and savings banks in the early 2000s. There is evidence that the state-owned Landesbanks took advantage of their lower funding costs by dramatically increasing their bond issue volumes during the four-year period of transition (see Fischer, Hainz, Rocholl and Steffen 2012). The proceeds were disproportionately invested in relatively risky projects such as tranches of securitised US subprime mortgages. Moreover, the US has recently substantially deregulated the credit unions without considering their special governance structure. Other examples include: the spatial and product deregulation of the US savings and loan industry; the failure of the credit cooperatives in Japan in the very early stages of their 1990s banking crisis; the banking deregulation in France in the mid 1980s; and the run on the savings-bank sector in South Korea.

Our study has two clear policy implications: first, economic liberalisation should take into account the institutions’ (or industry’s) governance structure and its impact on economic behavior, especially risk taking. Second, liberalisation that unleashes growth might lead to undesirable outcomes if the former regulation was designed to inhibit risk taking or to maintain minimum safety standards.

References

Fischer, M, Hainz, C, Rocholl, J, Steffen, S (2012), „Government Guarantees and Bank Risk Taking Incentives”, AFA 2012 Chicago Meetings Paper.

Illueca, M, Norden, L, Udell, G (2013), "Liberalization and Risk Taking: Evidence from Government-Controlled Banks”, forthcoming, Review of Finance (Journal of the European Finance Association).

La Porta, R, Lopez-de-Silanes, F, Shleifer, A (2002), “Government ownership of banks”, Journal of Finance 57, 265-301.

Laeven, L, Levine, R (2009), “Bank governance, regulation and risk taking”, Journal of Financial Economics 93, 259-275.

 

Topics: Europe's nations and regions, International finance
Tags: banking, liberalisation, Spain

Associate Professor of Finance and Accounting at Universitat Jaume I

Associate Professor of Finance at the Rotterdam School of Management, Erasmus University; Director of the Risk Management Programme, Duisenberg School of Finance

Gregory F Udell

Chase Chair of Banking and Finance, Kelley School of Business, Indiana University