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Number 92-41, November 20, 1992

A Note of Caution on Early

Bank Closure
Penalties do not always have their intended
effects. Prohibition mayor may notreduce problems related to alcohol. The relationship between
the death penalty and murder rates is debated
passionately. Similar considerations arise in bank
regulation, where penalties designed to deter
banks from taking risks just might have the opposite effect. Specifically, a policy of closing troubled banks earlier aims to prevent unsound banks
from taking big risks at the expense of the deposit
insurance fund; the catch is that recent banking
research indicates some banks may respond to
earlier closure by taking on more risk. This Letter
describes this new research, and argues that the
effect can be mitigated by imposing a larger
number of smaller penalties in a policy of graduated intervention, as under the new federal bank
regulatory policy of "prompt corrective action"
taking effect on December 19th.

Capital ratios and bank closure
Economists usually measure bank capital ratios
(capital divided by assets) at market value, since
losses to the deposit insurance fund at failed
banks depend on the values that seized bank
assets bring in the market. The most straightforward market-based regulatory closure principle
is to close a bank if its market value capital ratio
is zero or less. A policy of "early closure" departs from this basic rule, establishing a positive
capital ratio threshold below which banks are
closed even though they are solvent. For example, the closure threshold might be set at 4 percent of total assets.
Some of the arguments for early closure are
based on potential biases in bank accounting
practices that might cause the book value of
bank capital to systematically overstate true market capital. But accounting rulemakers and bank
regulators are moving steadily toward increased
collection and disclosure of information related
to market value, so this reasoning is losing
strength. More interesting versions of early closure argue for closure at positive market values,
and it is these versions that are the focus of this

Other people's money
One of the problems with banks that are near
failing is that the owners may feel a strong urge
to gamble. When the value of the owners' investment has fallen to near zero, they have little to
lose and much to gain from speculative, high-risk
ventures that have slim chance of success but
could save the bank. This "moral hazard" problem is well known and is not unique to banking;
the same thing can and does happen in other
lines of business as well. But unlike other businesses, banks can get their gambling money
through federally guaranteed customer deposits.
Nonbank firms operate on financing supplied by
creditors who are themselves at risk, and hence
are apt to watch closely and become nervous if
the money isused for excessively risky investments. Nervousness translates into higher interest
rates on credit extended, or perhaps into withdrawal of financing altogether. Awareness of this
risk sensitivity keeps moral hazard in check at
nonbank firms.
Most banks do not face such a constraint on their
actions: insured depositors have little incentive
to monitor what their banks do, since they will
be reimbursed by the deposit insurer if the banks
lose their money. For the banks, any gains are
added to bank capital, the bulk of any losses are
shoved onto the deposit insurance system, and
the higher risk does not add to their interest expenses. But while banks and their insured depositors are happy, taxpayers may not be, since large
losses by the federal deposit insurance fund may
require an infusion of federal tax dollars. To control potentially costly moral hazard at banks,
banking supervisors at the Federal Reserve and
other regulatory agencies monitor the financial
condition of banks regularly. But supervision resources are limited, and some types of gambling
are exceptionally difficult to spot, so detection is
not perfect and some unhealthy banks succeed
in rolling the dice at public expense.
One way to deal with this moral hazard might
be to make sure that banks never operate in such
poor condition that they are tempted by high-risk

bets. Regulators could take prompt, early action
against solvent but financially troubled banks.
In the most extreme versions of this approach, a
policy of early closure would require that regulators seize and close poorly capitalized banks. If
moral hazard becomes especially pronounced at
capital below 4 percent, for example, then closure at 4 percent might nip the budding problem.

Incentive effects of early closure
A crucial question is: Does moral hazard stem



capital per S€, or from being close to

the closure threshold? if the former, then early
closure may have the desired effect. But if nearness to the closure point is what matters, pushing
the threshold up to some higher level simply
shifts the incentive problem to a new subset of
banks, albeit those with somewhat higher capital
ratios. There still be roughly the same number of
banks close to the new closure threshold, with
similar incentives to gamble.
Recent research in banking (Davies and McManus
1991, Levonian 1991) uses theoretical models to
examine this question. These models show that
most banks will raise their capital ratios; any
that do not maintain capital above the threshold
will be purged from the banking system. If early
closure had no other effects, this rise in capital
ratios would make banks less likely to fail. But
the theoretical models also show that it is proximity to the closure point, not low capital, that
gives banks incentives to gamble. Some of the
banks above the new, higher threshold will respond to the new policy by increasing their risktaking. Moreover, of the banks above the new
closure threshold, the weakest banks will have
the largest increase in the incentive to gamble.
Thus, although capital ratios will tend to be higher under early closure, the moral hazard problem
the policy aims to relieve may not diminish.
Why might weak banks be more inclined to
gamble under earlier closure? Banks always face
uncertainty about the eventual impact of business decisions on their capital ratios. One might
imagi ne the outcomes rangi ng from catastrophe
to bonanza; the bank has some idea of the
chances of ending up at any of the various points
on this spectrum. When compared to the basic
rule of closure at zero capital, early closure creates a new range of outcomes-where capital is
above zero but below the closure threshold-at
which unpleasant (that is, costly) things happen

to the bank. Banks rationally will take steps to
reduce the chances of landing in this "penalty
zone:' Banks with capital well above the threshold will take fewer ris·ks, thus reducing the odds
of large adverse changes in capital that might put
them down in that zone. But the large changes in
capital that come from riskier portfolios look relatively more attractive to banks close to the line,
because large changes tend to move them to
points outside the zone, while small changes
might put them squarely within it.

Just a theoretical problem?
Assessing the practical importance of this theoretical observation is vital for drawing policy
implications. Unfortunately, the theoretical models are unable to predict unambiguously the net
effect on the federal deposit insurance fund's finances. One problem is that the real size of the
penalty is unknown: How much does closure
really cost the owners of a bank? If the answer
is "not much," then any perverse effect of early
closure on incentives is likely to be immaterial.
A second weakness is that the models can predict the direction of changes in capital and risk,
but not the magnitude of the changes. As a result
of these weaknesses, theory alone cannot say
whether the overall increases in capital and the
reductions in risk-taking at some higher capital
banks will be sufficient to offset the predicted
rise in risk-taking at low capital banks.
However, the same types of models that generate
the theoretical predictions can be used to examine realistic hypothetical cases. An examination
of several cases using a sample of large
reveals that the problem may be of considerable
practical importance. For example, consider a
move from a policy of closure at zero to closure
at 4 percent of assets. Assume, for illustration,
that all banks increase their capital ratios by that
same 4 percentage points under the new policy.
In that case, about a tenth of the banks theoretically would have a stronger desire to gamble.
I found that the liability of the insurance fund
would double if that tenth increased risk by about
80 percent (measuring risk here by the statistical
standard deviation of the rate of return on assets),
even if the remaining nine-tenths of the banks
in the sample slashed risk by 90 percent. The
liability doubles despite the much lower risk at
most banks and the higher capital ratios at all
banks. While this scenario is not intended as a
"most likely case;' the assumed increase in risk
is not unbelievably large, and it should be obvious that such a doubling would be a calamity
for the deposit insurance fund.


In sum, there is no way to say with certainty that
early closure will make the banking system safer;

it might have the opposite effect, particularly
since it is weaker banks that may become bigger

What to do about it
The theoretical predictions cited above are
couched within the context of early closure policy, but the same principles apply to penalties of
any form that are imposed on banks at particular
capital ratios. The key element is that when capital falls below discrete, prespecified thresholds,
regulators force solvent banks to take actions that
the banks perceive to be against their individual
best interests. However, the size of the response
does depend in part on the size of the penalty;
the modeling described above shows that the
prospect of large intervention-related losses generates substantial increases in the incentive to
take risks. Compared to outright closure, less severe penalties such as restrictions on growth or
dividend payments therefore are less likely to
encourage increased risk-seeking by banks near
the threshold.
At nonbank firms, these problems largely are
avoided as investors gradually increase pressure,
in small increments, on firms whose financial
condition deteriorates; at no arbitrary point is a
large penalty abruptly imposed. The final step in
this gradual process is market closure (perhaps
through bankruptcy) at zero market capital. This
suggests the outlines of an ideal regulatory approach: a policy that imposes appropriately
gradual pressure on troubled banks would avoid
most of the undesirable moral hazard effects of
early intervention.
The continuous adjustment required might be
too much to ask of the existing supervisory system, but current plans for "prompt corrective
action" by federal regulators may represent a
sound compromise. Beginning in mid-December
of this year, restrictions will be placed on unhealthy banks at a number of capital thresholds;
the restrictions become progressively more severe at lower capital levels, but the increase in
the "pain" inflicted at each threshold is relatively
small. If regulatory action is viewed as a process
of turning out the lights at troubled banks, the
adverse effects of early intervention stem from
sudden changes in brightness. Early closure flips

a switch, plunging abruptly to black, whereas the
ideal policy for reducing the effects of moral hazard would turn a knob to dim the lights gradually

as appropriate. Prompt corrective action is analogous to a three-way bulb; regulators can go from
bright, to dimmer, to dimmest, so that the final
click of the switch, if needed, is not such a major

Part of the case for early closure of banks is that
it helps solve the moral hazard problem. However, the recent banking research cited in this
Letter indicates that early closure may make the
moral hazard problem at some insured banks
worse, not better. The weakest banks-those
least able to withstand losses-are the most
likely to respond by engaging in riskier financial
gambles. Hence, although earlier closure may
have significant benefits, it is important to recognize that banks near the closure threshold might
have a greater tendency to gamble with insured
depositors' money, which may increase the total
burden on the deposit insurer. The larger number
of smaller incremental penalties for low capital
banks that will be instituted under "prompt corrective action" may be a practical solution.
One broader lesson is that changes in banking
regulatory policy cannot ignore the likely responses of the regulated banks.lfthe only response
by bank managements to the change in closure
policy were to raise capital, then gambling probably would be reduced. However, one of the
factors in banks' decisions is regulatory policy
itself, making it unrealistic to assume that bank
portfolio decisions would not respond to regulatory change. Similar considerations have long
been familiar to economists in other policy areas:
measures that look attractive if behavior is static
can lose some of their gleam with recognition of
more realistic human behavior.

Mark E. Levonian
Research Officer
Davies, S. and D. McManus. 1991. "The Effects of
Closure Policies on Bank Risk-Taking:' Journal of
Banking and Finance (September) pp. 917-938.
Levonian, M. 1991. "What Happens If Banks Are
Closed 'Early'?" in Rebuilding Banking: Proceedings of the 27th Annual Conference on Bank
Structure and Competition. Federal Reserve Bank
of Chicago, pp. 273-295.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank .of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor 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, Fax (415) 974-3341.



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Index to Recent Issues of FRBSF Weekly Letter

10/9 92-35
10/16 92-36
10/23 92-37
10/30 92-38
11 /6 92-39
11/13 92-40


Is a Bad Bank Always Bad?
An Unprecedented Slowdown?
Agricultural Production's Share of the Western Economy
Can Paradise Be Affordable?
The Silicon Valley Economy
. EMU and the ECB
Perspective on California
Commercial Aerospace: Risks and Prospects
Low Inflation and Central Bank Independence
First Quarter Results: Good News, B'ad News
Are Big U.s. Banks Big Enough?
What's Happening to Southern California?
Money, Credit, and M2
Pegging, Floating, and Price Stability: Lessons from Taiwan
Budget Rules and Monetary Union in Europe
The Slow Recovery
Ejido RefOim and the NAFTA
The Dollar: Short-Run Volatility and Long-Run Adjustment
The European Currency Crisis
Southern California Banking Blues
Would a New Monetary Aggregate Improve Policy?
Interest Rate Risk and Bank Capital Standards
NAFTA and u.s. Banking

Tren hoi melNeuberger

The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.