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Does Assigning Priority to Deposits Affect Bank Conduct? Evidence from a Quasi-Experiment Piotr Danisewicz, Danny McGowan, Enrico Onali and Klaus Schaeck.

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Presentation on theme: "Does Assigning Priority to Deposits Affect Bank Conduct? Evidence from a Quasi-Experiment Piotr Danisewicz, Danny McGowan, Enrico Onali and Klaus Schaeck."— Presentation transcript:

1 Does Assigning Priority to Deposits Affect Bank Conduct? Evidence from a Quasi-Experiment Piotr Danisewicz, Danny McGowan, Enrico Onali and Klaus Schaeck

2 Introduction  Historically depositors have been protected during bankruptcy by having priority on claims (in the US national protection from 1993)  Following the Cypriot banking crisis the ECB has called for the introduction of depositor preference throughout the EU  Under Depositor Preference Legislation (uninsured) depositors have priority over general creditors on the residual assets of a failed bank  Proponents argue this will: 1.Prevent bank runs 2.Engender more stable banking through increased market discipline  But the banking industry is sceptical arguing DPL will: 1.Raise costs for customers 2.Destabilize the financial system 2

3 Introduction  We test the theoretical predictions made by Hardy (2013), Birchler (2000), and Osterberg (1996) regarding Funding costs, liability structure, profitability, soundness, and valuation  Our research is important for three reasons 1. We inform an important policy debate that has far-reaching consequences that are not understood 2. Provide empirical tests relevant to theories on debt structure and monitoring (Fama, 1980; Goldberg and Hudgins, 2002; Rauh and Sufi, 2010; Hackbarth and Mauer, 2012) 3. Advance understanding of how bank capital structure responds to regulation (Le Lesle, 2012; Gropp and Heider, 2010) 3

4 What do Depositor Preference Laws do?  The assets of a failed bank are paid out to creditors according to a claims structure  In most countries this looks like  DPL alters the claims structure by elevating uninsured depositors 4 Without DPL 1.Receiver 2.Secured creditors 3.Insured depositors 4.Uninsured depositors & general creditors 5.Shareholders With DPL 1.Receiver 2.Secured creditors 3.Insured & uninsured depositors 4.General creditors 5.Shareholders

5 Theoretical Outline  Modigliani and Miller (1958) irrelevance theorem: absent taxation, the composition of corporate financing has no effects unless it: 1.Influences the probability of bankruptcy 2.Affects the costs of bankruptcy  Hardy (2013) outlines a model of the bankruptcy process and the role of depositor preference within this  Creditors have a lobbying technology that is used to assert claims during bankruptcy proceedings  Lobbying is increasing in the residual assets of the failed bank 5

6 Theoretical Outline 6  Because DPL assigns priority to some creditors, it reduces lobbying, and banks’ funding costs  Depositors no longer face losing their capital: demand a lower interest rate  Reduces the expected costs of bankruptcy (through less lobbying)  The lower funding costs translate into higher profits (and increases firm value)  Endogenously lower the probability of bankruptcy  Because non-deposits are now junior, they demand higher interest rates (Osterberg, 1996)  Banks shuffle their liability structure  Birchler (2000) shows DPL leads to better/more efficient monitoring of bank conduct and risk taking

7 Theoretical Outline 7

8 Institutional Background  The assets of insolvent US banks are transferred to a receivership  The receiver’s task is to maximize the NPV of recoveries  The Banking Act of 1935 outlined a priority structure to the residual assets 1. Receiver 2. Secured creditors 3. Insured depositors {account balances < $100,000} (insured by FDIC) 4. Uninsured depositors (account balances > $100,000) & non-depositors 5. Holders of subordinated debt & shareholders 8

9 Institutional Background  30 US states opted to implement DPL between 1909 and 1993 (our analysis exploits 15 of these reforms) 9

10 Institutional Background  These state depositor preference laws elevated the priority of uninsured deposits 1. Receiver 2. Secured creditors 3. Insured and uninsured depositors 4. Non-depositors 5. Holders of subordinated debt & shareholders  Importantly (for our identification strategy) the state DPLs applied:  To state-chartered banks  But not to nationally-chartered banks 10

11 Data Description and Representativeness  Quarterly Call Report data for commercial and savings banks in the US  Sample covers 1983Q1 to 1993Q2 for banks in 15 enacting states 11

12  Sample includes 199,698 observations for 5,506 banks  Broadly, the sample appears representative of the US population 12 Data Description and Representativeness

13  Measure funding costs as ratio of  Total interest expenses, deposit interest expenses, non-deposit interest expenses to total liabilities  Liability structure:  Total liabilities to total assets, same for deposits and non-deposits  Bank soundness:  Z-score, non-performing loans, leverage ratio  Profitability  ROA, total interest income to total loans, ROE 13 Data Description and Representativeness

14 Identification Strategy 14

15 Identification Strategy: Treatment Exogeneity  Why were the laws enacted?  Motivation for the reforms is not systematically documented  But like national DPL, adoption seems driven by the FDIC lobbying for DPL following the failure of Penn Square in 1982  DPL made bank resolution easier by allowing purchase and assumption transactions that minimize disruption of the local economy  Argued DPL would improve market discipline by exposing non- depositors to greater losses in the event of bankruptcy  Because of the limited discussion behind states’ enactment of DPL, we run a series of exogeneity tests 15

16 Identification Strategy: Treatment Exogeneity 16

17 Identification Strategy: Treatment Exogeneity  No significant differences in any specification – DPL not influenced by our DVs – no simultaneity bias 17

18 Identification Strategy: Parallel Trends  To what extent do national-chartered banks act as a valid counterfactual? 18

19 Identification Strategy: Parallel Trends  Statistical tests confirm the graphical patterns  No significant differences in growth rates in the (immediate) pre-treatment period 19

20 Pricing Effects: Cost of Funds 20

21 Quantity Effects: Liability Structure  Shrinking of state-chartered banks following treatment  Declines in deposits  But substitute towards non-deposit liabilities 21

22 Quantity Effects: Liability Structure  What explains this behavior?  In equilibrium, and assuming risk neutrality, some depositors will move their deposits to CG banks that pay higher deposit interest rates  i.e. state-chartered banks lose out to nationally-chartered banks that were unaffected by DPL  TG banks make up for this by using more non-deposit funding 22

23 Quantity Effects: Market Shares  If our hypothesis is correct we should be able to document:  A decreasing reliance on deposit funding by state-chartered banks  Particularly among uninsured deposits 23

24 Collateralization  Do non-depositors collateralize their claims?  Important as this could inhibit resolution costs and time  No evidence for such phenomena 24

25 Soundness and Profitability  Policymakers emphasize that DPL will incentivize banks to operate safely, reducing the likelihood of failure  Non-depositors have stronger incentives to monitor banks’ risk exposure due to their junior claim  More skin in the game which makes them 1) withdraw funds; 2) refuse to roll over funds; 3) demand a higher risk premium; 4) demand collateral  These actions put constraints on the risk-taking behavior of banks’ asset allocation choices (Goldberg and Hudgins, 2002)  Market discipline consists of two dimensions 1. Monitoring: judge risk exposure and incorporate this information into security prices 2. Influencing: claimants exert pressure on the bank to change conduct 25

26 Soundness and Profitability  Evidence suggests this view is correct  Improvement in soundness, reduction in NPL, and leverage  Increase in profitability, and a reduction in the variance of returns 26

27 Threats to Identification 27  Conduct a battery of robustness checks to ensure our results are not confounded by OVB  Because our regressions include state-quarter FE, these factors must be collinear with treatment to bias our findings  1. Charter is a choice variable  A. Switching is infrequent (3.8%)  B. No significant effect of treatment on charter type  2. Texas real estate collapse coupled with the Tax Reform Act of 1986 coincided with DPL in Texas (1985)  Same findings when we omit Texas from the sample

28 Threats to Identification 28  3. Enactment of DPL in the northeast coincided with the New England banking crisis  Results unchanged when we omit CT, ME, NH, and RI  4. If treatment is exogenous the magnitude of the ATE should be the same regardless of whether control variables are included or not  This is indeed the case – very similar magnitudes  5. Placebo test – observed behavior should be specific to state-chartered banks and the actual treatment  Randomly assign placebo treatments to national-chartered banks at the time of DPL enactment: no significant effect

29 Threats to Identification 29  6. Bertrand, Duflo and Mullainathan (2004)  Where the DV is serially correlated through time, DD estimators will yield spuriously low standard errors  Our regressions cluster at the “block” level (bank)  Check robustness to myriad permutations of the error structure  Same results when we cluster at the state level (only 15 groups!)  We also collapse the data upon a pre- and post- treatment period for each bank – similar results as before

30 Valuation Effects  A key prediction made by Hardy (2013) is that the reduction in funding costs raises firm valuations  This is consistent with the previous results  We now address how shareholders responded to DPL  This necessitates an alteration to the empirical methodology  Use event-study methodology to inspect what happened to stock returns following implementation of national DPL in 1993 30

31 Valuation Effects  National DPL was implemented following enactment of the Omnibus Reconciliation and Budget Act of 1993  The Act was devoted mainly to fiscal policy issues and balancing the government budget  National DPL went under the radar  It was also unexpected, even by regulators: the FDIC had to issue an emergency rule on how to interpret the legislation  Use stock price data retrieved from Datastream 31

32 Valuation Effects 32

33 Valuation Effects 33  Shareholders seem to welcome DPL  Positive valuation effects in line with the theory  Mostly similar evidence for recent EU and UK announcements

34 Concluding Remarks  The implications of changes in the regulatory environment on bank conduct are difficult to gauge  Our natural experiment yields important insights on this issue and theoretical models’ predictions  Robust causal evidence that DPL leads to Lower funding costs Improved profitability Sounder banks Increased valuation No change in collateralization  While the context may differ, the cleanness of our experiment helps shed light on an important EU-wide issue 34

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