The impact of FDICIA on bank returns and
risk: Evidence from the capital markets
Aigbe Akhigbe
a, Ann Marie Whyte
b,*a
Florida Atlantic University, Boca Raton FL, USA b
Department of Finance, College of Business Administration, University of Central Florida, P.O. Box 161400, Orlando, FL 32816-1400, USA
Received 12 March 1999; accepted 4 November 1999
Abstract
This study examines the impact of the Federal Deposit Insurance Corporation Im-provement Act (FDICIA) of 1991 on bank stock returns and risk. We ®nd that FDICIA had a generally positive eect on bank stock returns and resulted in a signi®cant re-duction in bank risk. The extent of the risk rere-duction varies based on the capitalization, size, and credit risk of the institutions with poorly capitalized, large, and high credit risk banks experiencing the greatest risk reduction. The results obtained using two separate control groups also bolster the conclusion that FDICIAÕs passage resulted in a signif-icant decline in bank risk.Ó2001 Elsevier Science B.V. All rights reserved.
JEL classi®cation:G21; G28
Keywords:Bank risk; Wealth eects; Bank regulation
1. Introduction
The passage of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991 marked a signi®cant regulatory milestone for the www.elsevier.com/locate/econbase
*Corresponding author. Tel.: +1-407-823-3945; fax: +407-823-6676. E-mail addresses:[email protected] (A.M. Whyte).
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banking industry. The act contains several important provisions including improving the capitalization of the Federal Deposit Insurance Corporation (FDIC), more stringent capital requirements, early regulatory intervention in the aairs of troubled or undercapitalized banks, prompt failure resolution, and risk-based deposit insurance premiums.
This study examines changes in capital market measures of risk for a sample of bank holding companies (BHCs) and banks following the passage of FDICIA. A secondary focus of the study is to re-examine the wealth eects surrounding FDICIAÕs passage. Two previous studies by Madura and Bar-tunek (1995) and Liang et al. (1996) have examined the wealth eects of FDICIA. This study complements their work using a larger sample of insti-tutions and expands the analysis to include an examination of the impact of FDICIA on risk.
but do not consider the legislation's impact on bank risk. Since regulators are concerned with the solvency of the banking system, they are concerned with both wealth eects and risk changes associated with regulatory intervention. This study ®lls a gap in the literature by examining changes in bank risk fol-lowing FDICIA's passage.
Studies focusing on the impact of regulation on bank risk include Mingo (1978), Koehn and Stangle (1980), Smirlock (1984), Allen and Wilhelm (1988), Bundt et al. (1992) and Sundaram et al. (1992). Mingo (1978) ®nds that de-posit-rate ceilings increase a bank's total risk while Koehn and Stangle (1980) ®nd that systematic risk is not aected by deposit rate ceilings. Smirlock (1984) provides evidence that the deregulation of deposit rates resulting from the passage of the DIDMCA of 1980 had no impact on systematic or unsystematic risk. Similar ®ndings are documented by Allen and Wilhelm (1988). However, Aharony et al. (1988) ®nd that DIDMCA's passage resulted in an increase in total risk for both money center and regional banks but a decrease in total risk for thrifts. More recently, Bundt et al. (1992) provide evidence that DID-MCA's passage resulted in increases in both systematic and unsystematic measures of bank risk. Sundaram et al. (1992) show that the passage of the FIRREA of 1989 increased the risk of both banks and S&Ls. Finally, Alex-ander and Spivey (1994) ®nd that less capitalized institutions experienced a signi®cant decrease in risk following CEBAÕs passage.
Overall, these studies provide ample precedent for the proposition that regulation can potentially impact both shareholder wealth and risk. Further-more, they suggest that the impact is likely to be dependent on factors such as bank size and capitalization. Accordingly, this study examines the impact of FDICIA on shareholder wealth and bank risk. Previous studies by Madura and Bartunek (1995) and Liang et al. (1996) have already demonstrated that FDICIA's provisions resulted in signi®cant wealth eects for bank share-holders. We add to these studies by using a broader sample of institutions and examining the impact on bank risk. FDICIA's passage may have contributed to a change in bank risk since several key provisions of the legislation are aimed at promoting stability and discouraging excessive risk taking in the banking in-dustry. For example, the imposition of more stringent capital requirements should reduce bank risk, particularly in the case of poorly capitalized banks. Similarly, the introduction of risk-based insurance premiums imposes market discipline and should reduce risk-taking behavior on the part of banks.
The empirical evidence is consistent with the proposition that the wealth eects of FDICIA are generally positive. Furthermore, the evidence shows that the institutions experienced a signi®cant reduction in total, systematic, and unsystematic risk following FDICIAÕs passage, and the results vary based on the capitalization, size, and credit risk of the institutions. In particular, we ®nd that poorly capitalized, large, and high credit risk banks experience the greatest reduction in risk. The results for two separate control groups provide further support for the conclusion that the observed reduction in bank risk is attrib-utable to FDICIAÕs passage and not to economy-wide forces. In contrast, there is no evidence of a signi®cant change in interest rate risk in the wake of FDICIAÕs passage. This result is not surprising since FDICIA does not ex-plicitly address interest rate risk. Consequently, banks are not motivated to alter their interest rate exposure in the wake of FDICIAÕs passage. Overall, the ®ndings support a signi®cant reduction in risk in the banking industry fol-lowing the passage of FDICIA.
These ®ndings have important implications for regulators and shareholders. Regarding regulators, it appears that FDICIAÕs provisions including risk-based capital requirements, risk-risk-based insurance premiums, limited discount window access, and prompt corrective action had the desired eect on bank risk. Regarding stockholders, the results suggest that well diversi®ed share-holders should reduce their required rates of return on bank stocks in the wake of FDICIAÕs passage.
The remainder of the paper is organized as follows. First, hypotheses related to key provisions are developed and the possible implications for changes in bank risk are presented. Next, the data and methodology are detailed and the results are discussed. Finally, the conclusions are presented and the implica-tions are oered.
2. Hypotheses related to key provisions of FDICIA
This section outlines key provisions of FDICIA and the possible implica-tions for bank risk.1From an investment standpoint, stockholders who hold well-diversi®ed portfolios are only concerned with the systematic risk of an institution. Thus, if FDICIAÕs passage does not impact systematic risk, stockholders should be indierent to this type of regulation. If, however,
1
FDICIAÕs passage reduces systematic risk, stockholders should reduce their required returns accordingly. From a regulatory standpoint, the total risk of an institution is relevant, not just systematic risk (Mingo, 1978). Peltzman (1976) argues that regulation alters the riskiness of the regulated ®rm by lowering the variability of earnings which should reduce both systematic and unsystematic risks. Accordingly, this study examines the impact of FDICIAÕs passage on total, systematic, and unsystematic risks and, as such, provides implications for both stockholders and regulators.
Several key provisions of FDICIA are likely to contribute to a signi®cant change in bank risk. Based on the literature review and the evidence provided by Madura and Bartunek (1995) and Liang et al. (1996) for the wealth eects of FDICIA, the legislationÕs impact on risk may vary with bank capitalization and size. Thus, the hypotheses are developed for each provision based on bank capitalization and size. We also examine whether the risk changes vary based on the credit risk of the institutions.
2.1. Improving the capitalization of the FDIC
FDICIA provided a temporary injection of an additional $30 billion into the FDIC. Under FDICIA, permanent capitalization of the FDIC is provided by the deposit insurance premiums paid by banks. This improved capitalization may have conveyed a positive signal to the market and may have reduced the marketÕs perception of risk since the FDIC is now better positioned to handle losses in the event that a failure occurs. This argument suggests that all banks, irrespective of capitalization, size, or credit risk, may experience an overall reduction in risk.
2.2. Prompt corrective action
to asset ratios and to invest in riskier assets than small banks since they are more diversi®ed. To the extent that FDICIA threatens early intervention, large, poorly capitalized banks should have an incentive to decrease their risk-taking activities. Similarly, banks with high credit risk and low capital to asset ratios should also have an incentive to reduce risk to avoid the threat of early closure.
2.3. Discount window access
FDICIA limits the access of undercapitalized banks to the discount window, eectively curtailing the ability of these institutions to boost short-term li-quidity by borrowing from the discount window. This provision should serve as an incentive for undercapitalized banks to quickly improve their capital positions or face closure by regulatory authorities. The same incentive should exist regardless of size since both large and small banks would have limited access to the discount window if they become signi®cantly undercapitalized. High credit risk banks would also have an incentive to reduce risk since they can no longer rely on the discount window to provide temporary liquidity.
2.4. Too-big-to-fail doctrine
FDICIA eectively eliminates the too-big-to-fail doctrine (Wall, 1993). The act prohibits the FDIC from protecting deposits above the maximum insurance limit, and provides that exceptions can only be made by agreement of the FDIC, the Federal Reserve, and the Treasury. This provision may increase the perceived riskiness of large banks since the FDIC will only provide limited coverage in the event of failure. On the other hand, large banks now have an incentive to reduce risk since they can no longer rely on the FDIC to rescue them or to protect uninsured depositors. Thus, de jure uninsured depositors who are aware of this change now have an incentive to monitor the activities of banks thereby limiting the risk-taking activities of banks. Large banks may, therefore, experience a reduction in risk following FDICIAÕs passage.
2.5. Risk-based deposit insurance premiums
FDICIA mandates risk-based deposit insurance premiums, with undercap-italized banks being forced to pay higher insurance premiums than well capi-talized banks. This provision reduces the moral hazard problem and should encourage banks to reduce excessive risk-taking since they will ultimately be penalized with higher insurance premiums. Based on this provision, high risk banks (poorly capitalized and or high credit risk banks) should experience a signi®cant reduction in risk.
experience a reduction in risk in the post-FDICIA era relative to the pre-FDICIA era.
3. Data and methodology
The eects of FDICIA on shareholder wealth and bank risk are examined using daily common stock returns for BHCs and banks over the period sur-rounding FDICIAÕs passage. The sample is constructed by identifying all in-stitutions on the Center for Research in Security Prices (CRSP) tapes with 602, 603 or 671 as the standard industry classi®cation (SIC) code, and which have returns for 300 trading days in the pre- and post-event periods. After gener-ating this list, theMoodyÕs Bank and Finance Manualfor 1991 is used to verify that the listed institutions are indeed BHCs or banks. This procedure resulted in a ®nal sample of 322 BHCs and banks.
As with most regulations, the legislative process surrounding FDICIAÕs passage was complex and involved the announcement of various events leading up to the ®nal passage of the law. Table 1 identi®es the date of each event and provides a brief description. The event dates and descriptions are obtained from Table 1 of the Liang et al. (1996) study and are presented here to provide clarity in interpreting the results.
The SUR model is used to estimate the share price response of the bank portfolios. Johnston (1984) argues that in the presence of contemporaneous correlation the SUR methodology generates more ecient estimates. The model is estimated as
RptapbmpRmtbipRit
X9
k1
cpkDkept; 1
whereRptis the return on the bank portfolio on dayt,apthe intercept term,bmp measures market/systematic risk of the portfolio,Rmt the return on the CRSP equally-weighted market portfolio on dayt,bip measures interest rate risk of the portfolio,Rit the daily change in the interest rate on the 30 year Treasury bond,2cpk measures the sensitivity of the portfolio to eventk, Dk a dummy variable equal to 1 for thekth event date and 0 otherwise,eptis the disturbance term on the portfolio on dayt.
Eq. (1) is estimated using daily returns for all trading days in 1991. The model is estimated for all banks and several additional bank portfolios based
2
on capitalization (well capitalized, moderately capitalized, and poorly capi-talized banks), size (large, medium-sized, and small banks), and credit risk (high, moderate, and low credit risk banks). The data on capitalization, size, and credit risk are obtained from the Bank Condition and Income database on the Federal Reserve Bank of ChicagoÕs web site. The data from the Bank Condition and Income reports are matched to the original sample of 322 banks using theMoody's Bank and Finance Manual for 1991.
The impact of FDICIA on risk is estimated using the methodology outlined by Aharony et al. (1986, 1988) and Smirlock (1984). The risk measures are estimated over a short-term interval and a long-term interval. The short-term interval includes 100 trading days prior to the event period and 100 trading days after the event period. The long-term interval includes 300 trading days prior to the event period and 300 trading days after the event period. Recog-nizing that the numerous announcements leading up to FDICIAÕs passage may alter the marketÕs expectations, we de®ne the pre-event period as the interval preceding the ®rst announcement (D1) on 1 February 1991 that the chairman
of the FDIC stated that the Bank Insurance Fund (BIF) needed a signi®cant cash infusion. Similarly, the post-event period is de®ned as the interval fol-lowing the last news announcement that the bill had been signed into law on Table 1
Events surrounding the passage of FDICIAa
Event Date Event description
D1 1/2/91 FDIC chairman says the Bank Insurance Fund needs cash infusion of up
to $10 billion
D2 6/5/91 The Federal Reserve Bank opposes an important provision in the bill
that could restrict its ability to provide liquidity to troubled banks D3 8/5/91 The House Financial Institutions Subcommittee approves a bill requiring
regulators to intervene quickly in the aairs of weak banks. The bill also improves the insurance fund and imposes new auditing standards on banks
D4 1/7/91 House Banking Committee votes to accept most of the Bush
Adminis-trationÕs proposals to restructure banking laws
D5 5/11/91 House defeats banking bill but the House Banking Committee is
expected to rewrite the bill
D6 7/11/91 House Banking Committee passes a scaled down version of the banking
bill
D7 22/11/91 House and Senate pass separate bills which provide a $70 billion line of
credit to the FDIC and impose new regulations aimed at reducing bank failures
D8 27/11/91 House accepts Senate provision requiring banks to repay (through higher
insurance premiums) a $30 billion line of credit over a 15 year period D9 20/12/91 President signs FDICIA into law
a
December 20, 1991 (D9). The capital market measures of risk are obtained
using the two-index model which has been utilized extensively in the banking literature:3
RptapbmpRmtbipRitept; 2
where the parameters are as previously de®ned in Eq. (1).
One potential problem in using the two-index model is the need to specify the relationship between the interest rate change and the market return. Some studies have dealt with this problem using orthogonalization (Chance and Lane, 1980; Flannery and James, 1984b). However, as noted by Giliberto (1985) and Kane and Unal (1988) the orthogonalization procedures produce biased t-tests. Thus, following Kane and Unal (1988) this study uses the un-orthogonalized two-index model.4Based on Eq. (2) the variance of the return on the portfolio is given by
Var Rp b2mpVar Rm b2ipVar Ri Var ep; 3
where Var is the variance operator. The terms Var Rmand Var Rire¯ect market wide factors, whereas b2mp, b2ip, and Var ep are aected by portfolio speci®c characteristics. Thus, changes in the variance of bank returns Var Rp could be due to changes in market risk b2mpVar Rm, interest rate risk b2ipVar Ri, or unsystematic risk Var ep.
5
3
See, for example (Flannery and James, 1984a,b; Aharony et al., 1986, 1988).
4
To provide further justi®cation for using the unorthogonalized two-index model, Eq. (1) is re-estimated as follows. First, the following equation is re-estimated:RitaptbimRmtept. Then, the residuals from the equation are substituted into Eq. (1) for the interest rate index (Chance and Lane, 1980; Aharony et al., 1986). The results using the orthogonalized model are qualitatively similar to those obtained using the unorthogonalized model. Hence, the results for the unorthogonalized model are reported. The complete results are available from the authors.
5Eq. (3) implicitly assumes independence between the interest rate series
Ritand the market return Rmt. To determine whether a covariance term needs to be included in the equation, Eq. (3) is re-estimated as
Var Rp b2mpVar Rm b 2
ipVar Ri 2bmpbipCov RmRi Var ep:
In all instances, inclusion of the covariance term did not materially alter the variance estimates. For example, in the pre-FDICIA short-term period for the portfolio of all banks, the covariance term is calculated as: 2 1:0109 0:0042 ÿ0:000019 0:0000002. Addition of this result to the original
The following hypotheses (H) are tested for the sample of all banks:
The hypotheses are also tested for several subsamples based on capitalization, size, and credit risk.6
The analysis is also conducted for two separate control groups. The analysis of control groups is necessary because during the period surrounding FDI-CIAÕs passage, a number of events occurred that may have had an impact on bank risk. First, Berger (1995) argues that banks were generally riskier in the 1980s but raised capital above optimal levels in the early 1990s because of regulatory changes and unexpectedly high earnings. Second, the Federal Re-serve had taken steps to counteract the economic recession and improve bank capitalization such as reducing the reserve requirements in 1990 (Cosimano and McDonald, 1998). Finally, the overall economic recovery may have con-tributed to a decrease in bank risk independent of FDICIA.
To test whether the changes in risk documented for the sample of banks are most likely attributable to FDICIA and not to these other factors, the above analysis is repeated for two dierent control samples; ®nance companies and real estate investment trusts (REITs). Finance companies are in the same line of business as banks on the asset side of their balance sheet, but are not subject to the provisions of FDICIA since they do not hold deposits. Similarly, REITs would be subject to the same real estate problems as banks but would not be subject to the provisions of FDICIA. Thus, both ®nance companies and REITs represent the best pool of ®rms for constructing control samples. The sample of ®nance companies and REITs is obtained from the list provided in volume two of the
Moody's Bank and Finance Manualfor 1991. The list is then used to identify those ®nance companies and REITs which are publicly traded and for which return data are available on CRSP over the sample period. This procedure resulted in a ®nal sample of 93 ®nance companies and 85 REITs. Since the provisions of FDICIA do not apply to these ®rms, they should not experience a signi®cant
H1 There is no signi®cant dierence in total risk in the pre-and post-FDICIA era for the equally-weighted portfolio of all banks. H2 There is no signi®cant dierence in systematic risk in the pre-and
post-FDICIA era for the equally-weighted portfolio of all banks. H3 There is no signi®cant dierence in interest rate risk in the pre-and
post-FDICIA era for the equally-weighted portfolio of all banks. H4 There is no signi®cant dierence in unsystematic risk in the pre-and
post-FDICIA era for the equally-weighted portfolio of all banks.
6The analysis was also conducted for three portfolios formed on the basis of the interest rate risk
reduction in risk following FDICIAÕs passage. Thus, the results of the control samples will enable us to determine whether the observed changes in bank risk are most likely attributable to FDICIAÕs passage.
4. Results
Table 2 provides a summary of the sample characteristics based on data obtained from the Bank Condition and Income database. The table shows the sample size and the mean and median capital to asset ratio, total assets, and nonperforming loans to total assets for the sample banks over the three year period prior to FDICIAÕs passage. The sample is partitioned into thirds for each variable; upper third, middle third, and lower third. The full sample consists of 322 institutions and the upper, middle, and lower thirds have 108, 107 and 107 institutions, respectively. The mean (median) capital to asset ratio is 7.86 (7.28)% for all banks, 10.45 (9.42)% for the upper third (well capitalized
Table 2
Sample characteristics for all banks and portfolios based on capitalization, size, and credit riska
Mean capital to
Well capitalized banks 10.45 9.42 108
Moderately capitalized banks 7.26 7.29 107
Poorly capitalized banks 5.90 6.00 107
Mean total
High credit risk banks 9.60 5.13 108
Moderate credit risk banks 1.09 1.08 107
Low credit risk banks 0.25 0.24 107
aThis table shows the mean and median capital to asset ratio, total assets, and credit risk (measured
banks), 7.26 (7.29)% for the middle third (moderately capitalized banks) and 5.90 (6.0)% for the lower third (poorly capitalized banks). The mean total assets for the sample of 322 banks is $5.4 billion while the median is $0.82 billion. The upper third (large banks) has mean (median) total assets of $14.92 billion ($6.56 billion), the middle third (medium-sized banks) has $1.01 billion (0.82 billion) while the lower third (small banks) has total assets of $0.26 billion ($0.25 billion). Finally, the mean (median) ratio of nonperforming loans to total assets for all banks is 3.65 (1.08)%, 9.60 (5.13) for the upper third (high credit risk banks), 1.09 (1.08) for the middle third (moderate credit risk banks) and 0.25 (0.24) for the lower third (low credit risk banks).
Table 3 shows the share price response of the bank portfolios to the events surrounding FDICIAÕs passage. The portfolio of all banks reacted positively (return of 0.8%) to the news that the chairman of the FDIC stated that the BIF needed an infusion of up to $10 billion (D1). The same positive pattern is
ob-served for the portfolios of poorly capitalized, moderately capitalized, and me-dium-sized banks although the portfolio of poorly capitalized banks is only marginally signi®cant at the 10% level. Overall, the portfolios do not experience a signi®cant reaction to the events D2through D8. The ®nal event D9, results in a
positive reaction for the portfolio of all banks (return of 0.9%) and the portfolio of poorly capitalized banks (return of 1.7%). The portfolio of large banks also experienced a return of 1.3% which is statistically signi®cant at the 10%. Overall, the results suggest that the news that the BIF would receive an infusion of up to $10 billion was good news for banks as was the ultimate passage of FDICIA (D9).
This suggests that the provisions of FDICIA aimed at improving the safety and soundness of the banking system had a positive impact on bank stocks.
Our results contrast with those documented by Liang et al. (1996). They re-port that banks reacted adversely to D1. In contrast, we ®nd that most portfolios
reacted favorably to D1. They document a positive reaction to D4(the news that
the House Banking Committee voted to accept most of the provisions of FDI-CIA) while we ®nd no signi®cant reaction to that event. They argue that this positive reaction suggests that some provisions of FDICIA were good news, on average, for the banking industry. Finally, we document a positive reaction to D9 while they ®nd no signi®cant reaction. Overall, we document a positive
re-action to FDICIA while they document both positive and negative wealth ef-fects. The dierence in results may arise because we use a comprehensive sample of 322 BHCs and banks while they use a sample of 164 BHCs.7Our results are
7
Table 3
ap 0.002 0.003 0.002 0.001 0.001 0.002 0.001
(1.508) (1.938) (1.759)
)0.03 )0.722 )1.612 )0.71
bmp 0.869 0.681 0.75 1.176 1.301 0.674 0.61
(28.941) (17.767) (21.513) (21.439) (25.026) (16.667) (12.583)
bip )0.023 )0.035 )0.026 )0.008 )0.027 )0.0271 )0.015 ()1.842) ()2.222) ()1.797) ()0.354) ()1.247) ()1.626) ()0.740) D1 0.008 0.002 0.009 0.012 0.009 0.015 )0.001
(2.027) (0.399) (2.075) (1.733)
D9 0.009 0.002 0.007 0.017 0.013 0.006 0.007
(2.197) (0.448) (1.470) (2.333) (1.883) (1.095) (1.107)
R2 0.697 0.468 0.566 0.559 0.631 0.447 0.305
Ad-justed R2
0.688 0.453 0.553 0.546 0.62 0.431 0.285
F
-Val-322 108 107 107 108 107 107
consistent with Madura and Bartunek's (1995) ®nding that medium-sized banks reacted favorably to the announcement of the bank reform proposal but are inconsistent with their ®nding that large banks reacted negatively. It should be noted, however, that Madura and Bartunek (1995) use a sample of 89 banks and use slightly dierent event dates than those in this study and in Liang et al. (1996).8
The major contribution of this study is the examination of the impact of FDICIA on bank risk. The results of this analysis are presented in Tables 4±7. Table 4 shows the change in the variance of the portfolio returns surrounding FDICIAÕs passage. The signi®cance of the changes in total risk is tested using anF-statistic under the null H that the variance of returns is equal in the pre-and post-FDICIA periods. The portfolio of all banks experienced a signi®cant reduction in total risk in both the short- and long-term intervals. Over the short-term interval the variance declines by approximately 62% (from 0.000068 to 0.000026) and over the long-term interval by 37% (from 0.000038 to 0.000024). In both instances the reduction is signi®cant at the 1% level. While most of the other bank portfolios experience a signi®cant decline in risk, the reduction is most dramatic for the portfolios of poorly capitalized, large, and high credit risk banks. Poorly capitalized banks experience a decline of 60% (0.000171±0.000068) and 40% (0.000086±0.000052) in the short- and long-term intervals, respectively, compared to a decline of 47% (0.000058±0.000031) and 0% (0.000033±0.000033) in the same intervals for well capitalized banks. Similarly, large banks experience a decline of 68% (0.000191±0.000061) and 55% (0.000099±0.000045) for the short- and long-term intervals, respectively, while small banks experience a decline of 30% (0.000115±0.000081) and an increase of 62% (0.000065±0.000105) in the same intervals. Finally, high credit risk banks experience a decline of 68% (0.000146±0.000047) and 51% (0.000075±0.000037) in the short- and long-term intervals, respectively, while low credit risk banks experience declines of 47% (0.000053±0.000028) and 15% (0.000033±0.000028) in the same intervals. It is interesting to note that the variance of the market portfolio also declines during the same period. Over the short-term interval, the variance of the market portfolio declines from 0.000051 to 0.000035 (a decline of 31%) and from 0.000041 to 0.000026 (a decline of 37%) over the long-term interval. Thus, the decline in total risk is partly related to the decline in the variance of market index over the same period. It is also
8
Table 4
Estimates of shifts in the variance of portfolio returns (Var Rp) by bank capitalization, size, and credit risk and estimates of shifts in (Var Rm) and (Var Ri)a
Portfolio Pre-FDICIA Post-FDICIA F-statistic
All banks
Short-term 0.000068 0.000026 2.61
Long-term 0.000038 0.000024 1.61
Well capitalized banks
Short-term 0.000058 0.000031 1.85
Long-term 0.000033 0.000033 1.01
Moderately capitalized banks
Short-term 0.000059 0.000025 2.32
Long-term 0.000037 0.000028 1.34
Poorly capitalized banks
Short-term 0.000171 0.000068 2.52
Long-term 0.000086 0.000052 1.66
Large banks
Short-term 0.000191 0.000061 3.13
Long-term 0.000099 0.000045 2.21
Medium-sized banks
Short-term 0.000062 0.000030 2.04
Long-term 0.000036 0.000027 1.31
Small banks
Short-term 0.000115 0.000081 1.42
Long-term 0.000065 0.000105 1.63
High credit risk banks
Short-term 0.000146 0.000047 3.13
Long-term 0.000075 0.000037 2.01
Moderate credit risk banks
Short-term 0.000084 0.000057 1.48
Long-term 0.000048 0.000056 1.16
Low credit risk banks
Short-term 0.000053 0.000028 1.89
Long-term 0.000033 0.000028 1.18
Finance companies
Short-term 0.000118 0.000143 1.22
Long-term 0.000077 0.000108 1.41
REITs
Short-term 0.000068 0.000052 1.31
Long-term 0.000043 0.000072 1.67
Market portfolio
Short-term 0.000051 0.000035 1.48
interesting to note that the variance of the interest rate index does not change signi®cantly during the same period.
The results for the control group of ®nance companies show an increase in the variance of the portfolio returns in the short-term but the change is insigni®cant. Over the long-term interval, however, the variance actually in-creases by 40% (from 0.000077 to 0.000108) and the increase is statistically signi®cant at the 1% level. Similar results are documented for the control sample of REITs. Although the variance decreases in the short-term the decline is statistically insigni®cant. Over the long-term interval, however, the variance increases and the increase is signi®cant at the 1% level. This result is the op-posite of that which is observed for the bank portfolios and provides prelim-inary evidence that the decline in bank risk is most likely attributable to FDICIAÕs passage.
To identify the change in systematic risk following FDICIAÕs passage, the change in the market beta and the interest rate beta are also examined. These risk measures are particularly important to stockholders who hold well-di-versi®ed portfolios. TheF-statistic is used to test the signi®cance of the changes under the null H that the coecients are equal in both periods. The results are shown in Table 5. The market beta for all banks declines from 1.0109 to 0.6787 (a decline of 33%) over the short-term period and from 0.8035 to 0.7161 (a decline of 11%) in the long-term period. In both instances, the decline is sta-tistically signi®cant. The portfolios based on capitalization show a reduction in risk in either the short- or long-term interval or both. However, the portfolios based on size show greater variation in the results. While large banks experi-ence a signi®cant reduction in risk in the short-term, small and medium-sized banks experience no signi®cant change in risk. The portfolios based on credit risk also provide some interesting insights. High credit risk banks experience the most dramatic and consistent decline in systematic risk in both short- and Table 4 (Continued)
Portfolio Pre-FDICIA Post-FDICIA F-statistic
Interest rate index
Short-term 0.000374 0.000349 1.07
Long-term 0.000313 0.000286 1.09
a
The short-term impact of FDICIA on total risk is assessed by computing the portfolio variance over a 100 day pre- and post-event short-term period while the long-term impact is assessed using a 300 day pre- and post-event period. TheF-statistics for the variances are based on (99,99) degrees of freedom in the numerator and denominator, respectively, for the short-term period and (299,299) degrees of freedom for the long-term analysis.F-statistics are calculated under the null hypothesis that the variances in the pre- and post-FDICIA period are equal and are calculated as Var(Group A)/Var(Group B). In all cases Group A refers to the group with the larger variance and Group B refers to the group with the smaller variance.
Regression estimates of market (bmp) and interest rate risk (bip): pre- and post-event results by bank capitalization, size, and credit riska
Portfolio Time interval (bmp) t-Statistic F-Statistic (bip) t-Statistic F-Statistic R
2
All banks
Short-term Pre 1.0109 17.854 0.0042 0.202 0.7696
Post 0.6787 12.568 18.032 0.0226 1.329 0.463 0.6249
Long-term Pre 0.8035 25.887 0.0040 0.353 0.6932
Post 0.7161 19.302 3.267 0.0154 1.381 0.519 0.5583
Well-capitalized banks
Short-term Pre 0.7922 10.898 0.0158 0.586 0.5523
Post 0.5235 6.551 6.189
)0.0345 )1.371 1.861 0.3123
Long-term Pre 0.6264 16.735 0.0086 0.634 0.4854
Post 0.5831 10.281 0.405 0.0089 0.524 0.001 0.2634
Moderately capitalized banks
Short-term Pre 0.8144 11.676
)0.0265 )1.026 0.5967
Post 0.5113 7.776 9.999 0.0642 3.094 7.485 0.4274
Long-term Pre 0.7195 20.185
)0.0143 )1.110 0.5811
Post 0.6033 12.446 3.732 0.0255 1.757 4.203 0.3483
Poorly capitalized banks
Short-term Pre 1.4549 12.783 0.0307 0.728 0.6291
Post 1.0067 10.409 9.007 0.0433 1.420 0.058 0.5358
Long-term Pre 1.0700 18.839 0.0176 0.856 0.5444
Post 0.9670 15.977 1.541 0.0137 0.755 0.020 0.4632
Large banks
Short-term Pre 1.5678 13.532 0.0254 0.591 0.6558
Post 0.9180 9.455 18.475 0.0075 0.246 0.115 0.4809
Long-term Pre 1.2013 20.968 0.0233 1.122 0.5968
Post 0.9058 16.217 0.654 0.0017 0.104 0.654 0.4698
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Table 5 (Continued)
Portfolio Time interval (bmp) t-Statistic F-Statistic (bip) t-Statistic F-Statistic R2
Medium-sized banks
Short-term Pre 0.7667 9.669
)0.0276 )0.940 0.5046
Post 0.6135 8.731 2.091 0.0390 1.760 3.276 0.4548
Long-term Pre 0.6243 15.596
)0.0234 )1.611 0.4561
Post 0.6460 13.899 0.126 0.0240 1.720 5.541 0.3987
Small banks
Short-term Pre 0.6549 4.747 0.0447 0.874 0.1888
Post 0.4428 2.980 1.095
)0.0097 )0.207 0.615 0.0839
Long-term Pre 0.5999 9.388 0.0411 1.777 0.2322
Post 0.6342 5.686 0.071 0.0221 0.661 0.219 0.0997
High credit risk banks
Short-term Pre 1.3260 12.292 0.0356 0.890 0.6101
Post 0.8120 9.791 14.268 0.0326 1.248 0.004 0.5045
Long-term Pre 1.0138 19.623 0.0397 2.122 0.5653
Post 0.7903 15.071 9.220 0.0244 1.552 0.393 0.4368
Moderate credit risk banks
Short-term Pre 0.9868 11.936
)0.0118 )0.386 0.6020
Post 0.7101 6.665 4.209 0.0462 1.374 1.625 0.3276
Long-term Pre 0.7925 18.754
)0.0243 )1.587 0.5467
Post 0.8019 11.200 0.013 0.0195 0.908 2.757 0.2989
Low credit risk banks
Short-term Pre 0.7350 10.372
)0.0077 )0.295 0.5329
Post 0.5207 7.026 4.368
)0.0116 )0.498 0.012 0.3374
Long-term Pre 0.6117 16.048
)0.0014 )0.101 0.4653
Post 0.5605 10.984 0.646 0.0030 0.196 0.046 0.2981
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Short-term Pre 0.9788 8.215 0.0246 0.558 0.4115
Post 1.2857 8.198 2.428 0.0815 1.649 0.736 0.4238
Long-term Pre 0.9067 15.251 0.0184 0.853 0.4392
Post 1.1497 11.680 4.468 0.0116 0.393 0.034 0.3153
REITs
Short-term Pre 0.6109 6.230
)0.0441 )1.214 0.3082
Post 0.4853 4.261 0.698
)0.0058 )0.161 0.563 0.1577
Long-term Pre 0.5068 9.818
)0.0163 )0.873 0.2486
Post 0.4773 5.120 0.077 0.0012 0.041 0.270 0.0811
a
This table shows changes in risk for several portfolios. The change in risk in the short-term period is assessed by computing thebs over a 100 day pre-and post-event period while the long-term impact is assessed using a 300 day pre- pre-and post-event period.F-statistics are calculated under the null hypothesis that thebs in the pre- and post-FDICIA period are equal. TheF-statistics are calculated as follows: ((residual sum of squares restricted model±residual sum of squares unrestricted model/q))/((residual sum of squares unrestricted model/nÿk)), whereqis the number of restrictions,nthe number of observations andkis the number of parameter estimates. Thus, theF-statistic has (1, 594) degrees of freedom in the long-term interval.
*Signi®cant at the 10% level. **Signi®cant at the 5% level. ***Signi®cant at the 1% level.
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Table 6
Estimates of shifts in unsystematic risk (Var(ept)) by bank capitalization, size and credit riska
Portfolio Pre-FDICIA Post-FDICIA F-Statistic
All banks
Short-term 0.000016 0.000010 1.60
Long-term 0.000012 0.000011 1.12
Well capitalized banks
Short-term 0.000026 0.000021 1.20
Long-term 0.000017 0.000025 1.44
Moderately capitalized banks
Short-term 0.000024 0.000015 1.64
Long-term 0.000016 0.000018 1.16
Poorly capitalized banks
Short-term 0.000063 0.000031 2.02
Long-term 0.000039 0.000028 1.40
Large banks
Short-term 0.000066 0.000032 2.07
Long-term 0.000040 0.000024 1.68
Medium-sized banks
Short-term 0.000031 0.000017 1.85
Long-term 0.000020 0.000017 1.18
Small banks
Short-term 0.000093 0.000074 1.26
Long-term 0.000050 0.000095 1.91
High credit risk banks
Short-term 0.000057 0.000023 2.46
Long-term 0.000033 0.000021 1.55
Moderate credit risk banks
Short-term 0.000033 0.000038 1.14
Long-term 0.000022 0.000039 1.80
Low credit risk banks
Short-term 0.000025 0.000018 1.33
Long-term 0.000018 0.000020 1.12
Finance companies
Short-term 0.000069 0.000083 1.19
Long-term 0.000043 0.000074 1.72
REITs
Short-term 0.000047 0.000044 1.08
Long-term 0.000032 0.000066 2.04
a
hy-long-term intervals. Over the short-term (hy-long-term) interval the beta of high credit risk ®rms declines from 1.3260 (1.0138) to 0.8120 (0.7903), a decline of 39% and 22%, respectively. Banks with moderate credit risk prior to FDICIA experienced no signi®cant risk reduction and low credit risk banks only ex-perience a reduction in risk in the short-term interval.
The results for the control group of ®nance companies show that they ex-perience a signi®cant increase in systematic risk in the long-term (from 0.9067 to 1.1497), the opposite of the pattern documented for the bank portfolios. The portfolio of REITs shows no signi®cant change in risk in either the short- or long-term intervals. This evidence bolsters the contention that the reduction in risk documented for the bank portfolios is most likely attributable to FDI-CIAÕs passage.
In contrast to the dramatic reduction in market risk, the results in Table 5 show that there is no signi®cant change in the sensitivity of most of the bank portfolios to changes in interest rates. This result is not entirely surprising since FDICIA does not explicitly address the issue of interest rate risk. Conse-quently, banks are not motivated to alter their interest rate exposure in the wake of FDICIAÕs passage. Thus, the results fail to reject the null H of no signi®cant change in interest rate risk in the banking industry as a result of FDICIAÕs passage. Similarly, there is no signi®cant change in interest rate risk for the two control groups considered.
Table 6 shows the results for changes in unsystematic risk. Once again, although most portfolios re¯ect a decrease in risk in either the short- or long-term interval or both, the decline is most dramatic for poorly capitalized, large, and high credit risk banks. While this ®nding is robust with respect to the time interval used, the short-term results are presented here to illustrate the point. Poorly capitalized banks experience a reduction of 52% in the short-term (0.000063±0.000031) while well capitalized banks experience a reduction of 19% (0.000026±0.000021). Over the same interval, large banks experience a reduction of 51% (0.000066±0.000032) while small banks experience a reduc-tion of 20% (0.000093±0.000074). Finally, high credit risk banks experience a decline of 60% (0.000057±0.000023) while low credit risk banks experience a decline of 28% (0.000025±0.000018), but the decline for low credit risk banks is statistically insigni®cant. The results for the control groups show that both ®nance companies and REITs experience no signi®cant change in risk in the short-term and both experience a signi®cant increase in unsystematic risk in the long-term.
pothesis that the variances in the pre- and post-FDICIA period are equal and are calculated as Var(Group A)/Var(Group B). In all cases Group A refers to the group with the larger variance and Group B refers to the group with the smaller variance.
**
Signi®cant at the 5% level.
***
Table 7
Changes in risk measures for portfolios based on various combinations of credit risk with the capital to asset ratio and sizea
Portfolio Interval bmp F-Statistic Var(Rpt) F-Statistic Var(ept) F-Statistic
Low capital to asset ratio, high credit risk banks
Long-term
Pre 1.3005 0.000154 0.000085
(15.609)
Post 0.9408 9.7701 0.000071 2.17 0.000048 1.76
(11.855)
Post 0.5934 0.1409 0.000051 1.06 0.000041 1.20
(8.054)
Large, high credit risk banks Long-term
Pre 1.2233 0.001063 0.000045
(20.144)
Post 0.9010 14.4099 0.000048 2.22 0.000027 1.67
(15.185)
Large, low credit risk banks Long-term
Pre 1.2594 0.000160 0.000095
(14.250)
Post 0.9911 4.1073 0.000100 1.61 0.000074 1.28
(10.052) a
This table shows changes in risk for four portfolios based on capitalization and credit risk and size and credit risk. The change in risk in the long-term period is assessed by computing the betas over a 300 day pre- and post-event period.F-statistics forbs are calculated under the null hypothesis that the bs in the pre- and post-FDICIA period are equal. TheF-statistics are calculated as follows: ((residual sum of squares restricted model±residual sum of squares unrestricted model/q))/((residual sum of squares unrestricted model/nÿk)), whereqis the number of restrictions,nthe number of observations andkis the number of parameter estimates. Thus, theF-statistic has (1, 594) degrees of freedom in the long-term interval. TheF-statistics for the variances are calculated under the null hypothesis that the variances in the pre- and post-FDICIA period are equal and are calculated as Var(Group A)/ Var(Group B). TheF-statistics for the variances are based on (299, 299) degrees of freedom in the numerator and denominator respectively.t-statistics are shown in parentheses.
***Signi®cant at the 1% level. **Signi®cant at the 5% level.
Table 7 provides some ®nal additional insights into the results. The table shows changes in the risk measures for four portfolios formed on the basis of various combinations of capital to asset ratio and credit risk and size and credit risk.9The results show that banks with low capital to asset ratios and high credit risk experienced a dramatic reduction in risk compared to banks with high capital to asset ratios and low credit risk. Thus, risky banks experienced the most signi®cant reduction. This is consistent with the earlier ®nding that poorly capitalized and high credit risk banks experienced the most signi®cant reduction in risk relative to well capitalized and low credit risk banks. The results also reveal that large banks, regardless of their level of credit risk, experienced a signi®cant reduction in risk in the wake of FDICIAÕs passage. This suggests that some of FDICIAs provisions, such as the elimination of the too-big-to-fail doctrine, may have motivated large banks to reduce their risk exposure.
Taken collectively, the results provide strong evidence that bank risk de-clined signi®cantly following FDICIAÕs. This ®nding is most dramatically apparent for banks which were risky prior to FDICIA (either poorly capital-ized or high credit risk) and relatively large banks. The results reject the null hypotheses that there is no signi®cant change in total, systematic and unsys-tematic risk (H1, H2, H4) over the pre- and post-FDICIA periods. The results do not, however, reject the null hypothesis that there is no signi®cant change in interest rate risk as a result of FDICIAÕs passage (H3). The results are par-ticularly strong given the fact that two separate control groups are used and both support the proposition that the reduction in risk for the bank portfolios is most likely due to FDICIAÕs passage. Although the economic recovery may have made it easier for banks to comply with FDICIAÕs passage, the evidence suggests that the provisions of FDICIA have contributed to a signi®cant re-duction in bank risk.
5. Conclusions
This study examines the impact of FDICIA on shareholder wealth and bank risk. The empirical evidence presented in this paper is consistent with the proposition that the wealth eects of FDICIA were generally positive. Re-garding the legislationÕs impact on risk, the evidence shows that the institutions experienced a signi®cant reduction in risk following FDICIA's passage, and the results vary based on the capitalization, size, and credit risk of the
insti-9
tutions. In particular, we ®nd that poorly capitalized, large, and high credit risk banks experience the greatest reduction in risk. The results for two separate control groups provide further support for the conclusion that the observed reduction in bank risk is most likely attributable to FDICIAÕs passage and not to economy wide forces. In contrast, there is no evidence of a signi®cant change in interest rate risk in the wake of FDICIAÕs passage. This result is not sur-prising since FDICIA does not explicitly address interest rate risk. Conse-quently, banks are not motivated to alter their interest rate exposure in the wake of FDICIAÕs passage. Overall, the ®ndings support a signi®cant reduc-tion in risk in the banking industry following the passage of FDICIA.
These ®ndings have important implications for regulators and shareholders. Overall, results suggest that FDICIAÕs passage contributed to a signi®cant reduction of risk in the banking industry. It appears that the FDICIAÕs pro-visions including risk-based capital requirements, risk-based insurance premi-ums, limited discount window access, and prompt corrective action had the desired eect on bank risk. Regarding stockholders, the results suggest that well diversi®ed shareholders should reduce their required rates of return on bank stocks in the wake of FDICIAÕs passage.
Acknowledgements
The authors would like to thank Carl R. Chen, Stanley D. Smith and two anonymous referees for helpful comments made on earlier drafts of this paper. The usual disclaimer applies.
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