Comments on “Bank Risk and
Regulatory Implications”
Lawrence J. White
Stern School of Business
New York University
lwhite@stern.nyu.edu
Presentation at the Asia-Link
Research Conference on “Safety and
Efficiency of the Financial System,”
Manila, 27th August 2007
Overview
Introduction
 Paper I: “The Efficiency of Banks…”
 Paper II: “The Regulation of Financial
Conglomerates…”
 Paper III: “Does Uncertainty Matter…?”
 Some additional comments
 Conclusion

Introduction
Finance is important
 Finance is special
 Banks are important
 Banks are special
 Safety and efficiency of banks are
important and important to understand

“The Efficiency of Banks…”:
What they did

1st 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 efficiency

2nd stage: OLS regressions to explain
average relative bank efficiencies, based
on bank and country characteristics
“The Efficiency of Banks…”:
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…”:
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…”:
Some cautions
Output measures neglect fee-based
activities
 Input measures are expenditures, not
physical inputs
 Prices of inputs are murky
 Does 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…”:
Some suggestions
More descriptive statistics for 2nd stage
 Are 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 Financial…”:
The purpose
Explain/describe financial conglomerates
 Review international regulatory practice
and recommendations
 Review existing Philippine regulations
 Offer recommendations

“The Regulation of Financial…”:
The findings
Financial conglomerates are a potential
problem
 International bodies recommend more
information, more coordination
 Philippines regulation is based on
specialties: BSP (and PDIC); SEC; IC
 Philippines regulation needs more
recognition of the conglomerate
phenomenon, more information sharing,
more coordination

“The Regulation of Financial…”:
Some cautions and suggestions

Explain the distinctions among different
goals and types of financial regulation
– Prudential regulation vs. consumer fraud
protection vs. information revelation
What 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…?”:
What they did

Develop 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…?”:
What they found

Banks 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…?”:
Some cautions

Selection 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 tstatistics) when capital ratio is included;
why?

“Does Uncertainty Matter…?”:
Some suggestions
More intuition as to implications of
improved loan recovery likelihood
 Try scaling charge-offs by NPLs or by loan
loss provisions
 F-test on big bank/small bank comparison
and include bank size in both regressions
 Direct 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 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)

Healthy, solvent bank:
Assets
100
Liabilities
92
8
(based on market values, of course)
Bank accounting 101 (B)

Unhealthy, insolvent bank:
Assets
80
Liabilities
92
-12
(based on market values, of course)
Banks are special (1)
Banks are opaque
 Banks 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 may fail because of mismanagement
– Bad loans and investments may cause insolvency

Banks may fail because of depositor runs
– Imperfectly informed depositors, fearing insolvency,
want to withdraw their funds quickly
Contagion
 Cascades


Bank closures have costs for their customers
– Depositors/creditors lose their funds
– Borrowers need to find other lenders
The 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 bank

Activities that are “examinable and supervisable”
– Regulators can set appropriate capital requirements
– Regulators can assess the competency of the
management of the activity
Why 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 bank

Activities that are not examinable and
supervisable
– Regulators cannot set appropriate capital
requirements
– Regulators cannot assess the competency of the
management of the activity
How 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?
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 repaid
 Sell stuff to the bank at excessively high prices
 Favor their friends (with loans, etc.)

What are appropriate activities
for the bank’s owners?
Anything that is otherwise legal; but
 All 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 Activities
Lines of ownership
Transactions to be closely monitored
Owners
(Other activities)
Holding company
(Other activities)
Bank
(examinable and
supervisable
activities)
Bank subsidiary
(other activities)
Holding company
Subsidiary
(other activities)
Implications for financial
regulation
Think “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”

Conclusion
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
