Academic journal article Federal Reserve Bank of St. Louis Review

Explanations for the Increased Riskiness of Banks in the 1980s

Academic journal article Federal Reserve Bank of St. Louis Review

Explanations for the Increased Riskiness of Banks in the 1980s

Article excerpt

1984-1985

Percentile              E1        E2          E3         E4
0-10                   9.4%      8.8%       10.4%      11.4%
10-20                  8.9      10.5         9.9       10.7
20-50                 27.8      32.7        30.0       29.5
50-80                 30.9      29.4        31.1       28.6
80-90                 10.8      10.0         9.9        9.3
90-100                12.2       8.5         8.7       10.6
Number of banks      2,928      2,991      3,013      2,899
Mean                0.0886     0.0867     0.0864     0.0865

INTEREST IN BANKING MATTERS surged in the 1980s, when the U.S. banking system experienced considerable difficulties after several decades of stability. During the decade, the number of bank failures increased sharply, and banks in general experienced increasing problem loans and dwindling capital. Most banks recovered their financial strength in the early 1990s thanks to improved economic conditions and low short-term interest rates that increased interest margins. With the recovery of the banking sector, public interest in bank failures is fading, but many questions remain unanswered. To effectively prevent repetition of the banking turmoil, it is important to study the fundamental causes of the sudden deterioration of the financial health of the banking system in the 1980s. Without recognizing the causes, future banking policies intended to improve the safety and soundness of the banking sector might produce more unintended effects than intended ones.

Numerous studies have proposed explanations for the deterioration of bank asset quality, but empirical evidence is sketchy. This study explores theoretical explanations for the financial problems of commercial banks in the 1980s and examines their empirical consistency. I focus on commercial banks because many previous studies have examined the financial problems of savings and loan associations (S&Ls). Three theoretical possibilities for the increased riskiness of banks in the 1980s are considered: (1) increased incentives for risk-taking by bank stockholders; (2) desperate attempts of bank managers to increase profits by assuming additional risk; and (3) unexpected economic shocks.

To evaluate the empirical significance of the three hypotheses, the empirical section examines the effects of capital adequacy and earnings on the risk-taking behavior of banks and also looks at the relationship between regional economic conditions and bank performance. Capital ratios and earnings may be related to the risk-taking incentives of stockholders and managers, respectively. Regional economic conditions should largely explain bank performance if unexpected economic shocks are the main reason for the deterioration of bank asset quality. For selected years of the 1980s, I divide banks into several groups based on year-end capital ratios and earnings on assets. I then compare year-to-year changes in various risk measures across groups. Although deliberate risk-taking by stockholders and managers does not appear to apply to the majority of banks, it is found to be consistent with the behavior of a sizable proportion of banks. This result holds even after controlling for the effects of local economic conditions.

The next section describes the economic and institutional developments that are related to the financial troubles in banking during the 1980s. The following section explores theoretical explanations for increased risk-taking and existing empirical evidence. Empirical results of this study follow. Lastly, the article's findings are summarized.

DEVELOPMENTS IN BANKING

The United States enjoyed stable banking during the four decades following the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1934. The relatively high number of bank failures between 1934 and 1942, about 44 per year, may be regarded as an aftermath of the financial crisis of 1933 and the following years of depressed economic activity. …

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