Frederick T. Furlong

English

Research Papers in Economics

FRBSF
March 25, 1988 WEEKLY LETTER
Changes in Bank Risk
In the 1980s, two countervailing trends have
been evident among the large bank holding
companies. On the one hand, their capital posi"
tions have improved while, on the other, their
asset portfolios have become more risky.
From a regulatory perspective, the general
improvement in capital positions is a positive
development, since it serves to reduce default
risk among banking institutions and to protect
the deposit insurance system, other things being
equal. However, default risk and the liability of
the deposit insurance system also depend on the
degree of asset risk assumed by banks. To the
extent that asset risk has increased in recent
years, the beneficial effects of the higher capital
levels in banking may have been offset.
This Letter discusses the changes in capital posi"
tions and asset risk among a sample of large
bank holding companies (BHCs) during the
1980s and evaluates the net effects of these
changes on the liability of the deposit insurance
system.
Improved capital ratios
Bank regulators typically measure the capital
position of a bank as the ratio of its capital to
assets. One measure of regulatory capital is "pri-
mary capital," which comprises mainly the book
value of common equity, loan loss reserves, and
perpetual preferred equity. The solid line in
Chart 1 traces the trend in the average book
value, capital-asset ratio for a sample of 98 large
BHCs from 1975 to 1986. The book-value ratio
rose from about 4% percent at the beginning of
1980 to more than seven percent in the third
quarter of 1987.
The rebound of capital ratios for the large BHCs
is even more remarkable when measured on a
market value basis. An approximate measure of
the market value of primary capital is the sum of
the market value of common equity (that is, the
stock price times the number of common shares
outstanding) and the par value of preferred
equity. From early 1980 to the thirdquarter of
J
1987, the average ratio of market value, primary
capital to book value assets more than doubled.
To a large extent, the rise in capital ratios among
banking organizations may be a response to reg-
ulatory policy. The bank regulatory authorities
began to place more emphasis on capital regula-
tion in the early 1980s, starting with an
announcement in 1981 of the first explicit mini-
mum capital ratios for banks and bank holding
companies. These requirements, which became
effective in mid-1982, were strengthened in
1983 and in 1985. The new capital require-
ments have made minimum capital standards
more or less uniform for all banking organiza-
tions and raised the effective capital standards
for many of the larger institutions.
Still more changes in capital requirements are
being proposed, with emphasis on international
standards for higher capital requirements that
are related to the asset risk of a bank. This focus
on risk-related standards reflects the concern
that simple minimum standards for capital ade-
quacy have not kept pace with possible
increases in asset risk.
Greater asset risk
One of the regulators' worries has been the rela-
tive decline in banks' holdings of low-risk, liquid
assets, such as Treasury and agency securities.
Another concern is the growing volume of prob-
lem loans related to the troubled energy, real
estate, and foreign sectors. As a result, banks
have posted sharp increases both in loan losses
and in their ratios of loan loss reserves to total
loans.
These simple measures of risk indicate that the
quality of bank asset portfolios has deteriorated.
Finance theory suggests a more comprehensive
measure of asset risk: the variation of the eco-
nomic rate-of-return on assets. This measure of
risk can be expressed as the standard deviation
of the rate-of-return on the market value of a
bank's assets. The higher is the standard devia-
tion, the greater is the degree of asset risk.FRBSF
The problem with this measure is that the market
value of many bank assets and, therefore, the
corresponding asset-return standard deviation
are not directly observable. However, this mea-
sure can be estimated using information on the
standard deviation of the rate-of-return on the
share prices of a bank holding company's com-
mon equity. The simplest approach is to approx-
imate the asset-return standard deviation as the
standard deviation ofthe return on common
equity, weighted by the bank's ratio of market
value capital to assets. This approach recognizes
that the risk of an institution is determined by its
asset risk and leverage. It also assumes bank lia-
bilities are not risky.
Such a measure of the average asset risk of 98
large BHCs is plotted in Chart 2 for the years
1975 to 1986. The chart shows that bank asset
risk has been higher in the 1980s than in the
second half ofthe 1970s. This rise in asset risk in
the 1980s is statistically significant.
Insurance system risk
A central policy question, and the primary con-
cern of this Letter, is the extent to which the
higher degree of asset risk has offset the benefits
of the improved capital positions of bank hold-
ing companies. A related concern is whether, on
balance, the risk exposure of the deposit insur-
ance system has increased.
Robert Merton has provided a convenient frame-
work for such an inquiry. He has shown that the
value ofthe deposit insurance guarantee is like a
(Black-Scholes) put option. The value of the
insurance guarantee (that is, the option) is
related to the amount ofleverage of a banking
institution and the standard deviation of the eco-
nomic rate-of-return on the bank's assets - the
two variables discussed above. The lower the
leverage, the lower will be the value of the guar-
antee since it is less likely that a bank will fail
and exercise the option and impose losses on
the insurance system. Likewise, the lower the
asset risk, the lower wi.ll be the value of the
guarantee.
The change i.n the value of the deposit insurance
guarantee was estimated for each of 98 large
bank holding companies using data for 1981
and again for 1986. (In making these calcula-
tions, a more refined estimate of the asset-return
standard deviation was used than the one
J
described above.) Since a number of simplifying
assumptions were necessary, estimates of the
value of deposit insurance to the sample of bank
holding companies must be viewed with cau-
tion, particularly with regard to the level of the
value of the guarantee. Nonetheless, changes in
those values should give a reasonable indication
of the magnitude of the changes in the risk to the
deposit insurance system.
The averages of the estimated value of deposit
insurance among the sample of bank holding
companies are presented in Chart 3. For refer-
ence, the maximum statutory deposit insurance
premium is about eight cents per $100 of
deposits. The chart shows a large and statis-
tically significant increase in the average value
of deposit insurance. This finding suggests that
the increase in asset risk has more than offset the
benefits from the decline in leverage among the
sample of bank holding companies on balance,
leaving the deposit insurance system at greater
risk. It also suggests that, on average, deposit
insurance was underpriced in 1986, but not in
1981. The latter result is consistent with other
studies that have estimated the value of deposit
insurance in the earlier part of the 1980s.
Cause or effect?
This evidence suggests that, adjusting for
increased asset risk, the "effective" average cap-
ital position among the sample of large BHCs
has become weaker, not stronger. An appropri-
ate regulatory response might be to require even
higher standards for capital adequacy.
Some might argue, however, that the observed
increases in bank asset risk were a direct conse-
quence of the required buildup in capital. Thus,
a regulatory push for even more capital would
lead to more risk-taking. This commonly held
view states that when banks are forced to raise
capital, they will shift to higher yielding, riskier
investments to maintain a target rate-of-return on
equity.
The theoretical underpinnings of this argument,
however, are not very sound. In fact, as dis-
cussed at length in a previous Letter (May 22,
1987), there are strong theoretical grounds for
believing that higher capital levels in banking
actually reduce a bank's gains from increasing
asset risk. Moreover, the common wisdom is not
supported by empirical evidence. If incentivesChart 1
Primary Capital to
Total Assets
Percent
8
Chart 3
Cents
Mean Value of per $100
Deposit Insurance of Deposits
16
* Significant at the 95 percent
level of confidence.
4
3
6
7
5
0.5
0.4
0.3
0.8
0.7
0.6
:0"
'.
.............
:...... .". V· ....
77 79 81 83 85 87
Chart 2
Asset Risk
Standard Deviation of
Return on Market
Value Assets
76 78 80 82 84 86
for risk-taking increase in response to higher reg-
ulatory capital requirements, then the effect
should be most evidentamong the "under-cap-
italized" BHCs that had to raise capital to meet
the new capital requirements in the 1980s. This
is not the case. Among the sample of 98 BHCs,
neither the increase in asset risk nor the change
in the value of deposit insurance were greater
for the BHCs that had to raise capital to meet the
minimum requirements in the 1980s than for the
other BHCs.
Conclusion
The benefit to the deposit insurance system from
the improvement in the capital positions of large
BHCs apparently has been more than offset by
increased asset risk in the 1980s. Put another
way, the findings in this Letter indicate that,
given the increase in asset risk among the large
BHCs, the effective capital positions of large
BHCs now likely are weaker than at the begin-
ning of the decade, despite the increases in capi-
tal to assetratios. The deterioration in the
effective capital positions among the large BHCs
argues for vigorous regulatory efforts to raise fur-
ther the level of capital in banking and to ensure
more rapid adjustments in capital requirements
to changes in asset risk in the future.
FrederickT. Furlong
Opinions expressed in this newsletter do not necessarily reflect the views of the management ofthe Federal Reserve Bank of
San Francisco, or of the Board of Governors ofthe Federal Reserve System.
Editorial comments may be adilressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.uo~6U!4S0m 4o~n U060JO 0pOA0U
040PI !!omoH O!UJoJ!l0) ouozPl:J o~soll:J
O)SI)UOJ~ UOS
JO ~uo8
aAJaSa~ IOJapa~
~uaw~Jodaa lpJOaSa~
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
3/02/88
Change
from
2/24/88
Changefrom 3/04/87
Dollar Percent?
Loans, Leases and Investments1 2 204,425 960 1,146 0.5
Loans and Leases1 6 180,866 758 - 2,310 - 1.2
Commercial and Industrial 51,523 494 - 751 - 1.4
Real estate 70,834 83 4,295 6.4
Loans to Individuals 36,107 - 77 - 3,764 - 9.4
Leases 5,761 - 20 394 7.3
U.S. Treasury and Agency Securities 16,519 224 3,277 24.7
Other Securities2 7,041 - 22 180 2.6
Total Deposits 204,304 3,998 - 1,496 - 0.7
Demand Deposits 50,477 3,271 - 2,556 - 4.8
Demand Deposits Adjusted3 33,793 1,207 - 1,136 - 3.2
OtherTransaction Balances4 20,513 607 914 4.6
Total Non-Transaction Balances6 133,314 120 146 0.1
MoneyMarket Deposit
Accounts-Total 43,275 84 - 2,254 - 4.9
Time Deposits in Amounts of
$100,000 or more 30,542 - 72 - 1,064 - 3.3
Other Liabilities for Borrowed MoneyS 21,557 - 446 - 5,969 - 21.6
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)lDeficiency (- )
Borrowings
Netfree reserves (+)lNet borrowed(-)
Period ended
2/22/88
28
6
22
Period ended
2/8/88
98
9
90
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change
j

Changes in bank risk

http://www.frbsf.org/publications/economics/letter/1988/el88-13.pdf

Changes in bank risk

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics