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February 24, 1989

Bank Charter Values and Risk
It has long been recognized that the fixedrate deposit insurance provided by the Federal
Deposit Insurance Corporation (FDIC) and the
Federal Savings and Loan Insurance Corporation
(FSLlC) creates an incentive for excessive risk
taking. Banks and thrifts have the ability to borrow at or below the risk-free interest rate by
issuing insured deposits regardless of the riskiness of their asset portfolios and their risks of
bankruptcy. Absent regulation, one would expect
these organizations to assume very risky asset
portfolios, hold as little capital as possible, and
have very high failure rates.
Recently, in fact, bank and thrift failure rates and
deposit insurance payouts have reached record
highs; the FSLlC has liabilities that exceed its
assets by as much as $100 billion; and some
economists even question the solvency of the
FDIC. These developments are exactly what one
might expect of a deposit insurance system that
subsidizes risk taking. But why are we facing
such large problems only now? Why didn't they
arise sooner? What is surprising is that the deposit insurance system worked as well as it did
for much of its 50-year history. This Letter argues
that declining charter values help to explain this

Increased risk
Some economists argue that the recent rise in
bank and thrift failures simply reflects an increasingly risky economy. In the last few years,
whole sectors and regions of the national and
even the world economy have encountered serious downturns that have affected the values of
bank and thrift assets. Similarly, interest rates
have become more volatile, increasing the riskiness of banks' and, especially, thrifts' portfol ios.
The rise in bank and thrift failures in recent years
also may reflect the secular decline in capital-toasset ratios over the past two decades. Lower
capital ratios provide less cushion against any
given loss, making failure more likely than otherwise. In fact, capital ratios have fallen well below
their levels in the 1950s and 1960s when only a

handful of banks and thrifts failed each year, as
opposed to several hundred per year recently.

But why now?
There is little doubt that increased risk in the
economy and declining capital ratios have had a
lot to do with the increase in bank and especially thrift failures in recent years. But these
developments do not explain why banks and
thrifts allowed bankruptcy risk to increase. After
all, depository institutions have considerable
control over the riskiness of their asset portfolios
and especially over their capital ratios.
One possible explanation for this behavior is that
unexpected economic events reduced the market
values of banks' and thrifts' assets and thereby
reduced the market (if not book) values of their
capital ratios. This explanation seems to fit particularly well the industry-wide problems encountered by the thrifts in the 1980s due to the
rise in interest rates during that period. Since the
incentive to increase asset risk and bankruptcy
risk increases as capital ratios decline, banks and
thrifts may well have chosen to hold much riskier
asset portfolios than they would have with higher
capital ratios. The reason is that as these institutions' capital fell, their owners had less (and in
some cases nothing) to lose in the event their investments fared poorly, but stood to profit handsomely if their investments yielded good returns.
However, for banks and some thrifts, this argument tells only part of the story. There still is the
question why capital ratios declined prior to the
1980s. There is also the question why some
banks and thrifts continue to hold more capital
than others and much more than is required by
regulation. Moreover, it does not explain the finding of several researchers that deposit insurance
actually appears to be overpriced for some institutions.

Bank charters
One explanation of these apparent puzzles
involves both differences across banks, and

changes over time, in the value of banks' charters. Banks may be chartered (that is, licensed) to
operate in a given location or locations by either
the Comptroller of the Currency or the individual
states. Since these chartering agencies have
tended to limit the number of charters they grant,
bank charters have tended to be quite valuable,
particularly in locations where.a given bank
faces relatively little competition.
Valuable charters, in turn, can. induce banks to
operate prudently, despite the incentives for risk
taking provided by deposit insurance. The reason
is that in attempting to take advantage of the
deposit insurance subsidy by taking on slightly
greater bankruptcy risk, banks also risk losing the
entire value of their charters in the event of
bankruptcy. This is especially so since a bank is
considered insolvent from a regulatory perspective when the value of its assets not including the
value of its charter falls below the value of its
obligations to depositors and other liability holders. As a result, for a bank with a near-zero probability of bankruptcy, the expected cost of losing
the charter through an increase in asset risk or
reduction in capital outweighs the benefits due
to subsidized deposit insurance, and banks will
choose voluntarily to limit their own risk taking.
Thus, as long as banks have near-zero probabilities of failure and bank charters are valuable,
banks themselves will have a powerful incentive
to keep asset risk and capital within acceptable
bounds. This makes the bank regulator's job
easier because valuable charters eliminate the
incentives for small increases in default risk.
Instead, a large, discrete increase in asset risk or
reduction in capital would be required to tip the
cost-benefit calculation in favor of risk taking. In
essence, the expected benefits from increased
risk taking would have to exceed the expected
loss of the charter. Such large changes presumably would be easy to detect and thus prevent,
and regulators would not need to be concerned
with small changes in asset risk or capital.
Another way of interpreting the effect of valuable
charters on bank risk taking is that regulators
have much greater leeway for error in determining the adequacy of capital relative to asset risk
at the time of examination. The greater the value
of the charter, the lower can be capital (not including the value of the charter) to attain a given

degree of risk exposure. The charter, in effect,
represents an extra capital cushion that the bank
cannot payout to its owners.

Declining charter values
As long as bank charters remain valuable, then,
the incentive of deposit insurance for excessive
risk taking is less problematic. But increasing
competition over time may have reduced the
values of many banks' charters, making bankers
more willing to take on increased risk. In the
1950s and even early 1960s, bank charters undoubtedly were quite valuable since banks were
partially protected from competition by a variety
of regulatory barriers. For example, chartering
was very restrictive until the mid 1960s, when
then Comptroller of the Currency James Saxton
took steps to liberalize it.
Moreover, banks were protected by various state
laws that limited or prohibited branching, and
multibank holding company expansion and interstate bank expansion also were widely prohibited. However, these laws have been greatly
liberalized in recent years, possibly eroding
banks' charter values. Likewise, deposit-rate
deregulation and deregulation of thrifts' powers
may have diminished charter values by increasing competition, especially for institutions in
protected local markets that had been relying on
non-price service competition to attract funds.
Finally, many argue that changes in technology
have increased the competition banks face from
nonbank financial firms such as investment
banks, brokerage firms, and insurance companies. For example, money market mutual funds,
cash management accounts, and increased use
of commercial paper all have made competitive
inroads in banks' traditional product markets.
Thus, it may be that during the 1950s and 1960s,
most bank charters were sufficiently valuable
and regulation was sufficiently stringent that
banks had little incentive to make marginal increases in bankruptcy risk and no opportunities
to make large discrete increases. This would
explain why deposit insurance historically appears to have been overpriced and why even
now it may be overpriced for many banking organizations with valuable charters (specifically,
those institutions that continue to operate in
markets that are to some extent protected from

competition). The desire to obtain and protect a
valuable charter could make banks willing to
pay a premium for deposit insurance since such
insurance is a prerequisite for a charter. The desire to protect a valuable charter from loss due to
bankruptcy also explains why even now, banks
with valuable charters would continue to hold
more capital than other banks and more capital
than regulators require.

solvency risk, as measured by market value capital-to-asset ratios, and charter values. That is,
BHCs with more valuable charters are better
capitalized. Moreover, charter values and capital-to-asset ratios are highly correlated over time,
and a banking organization's charter value is
an important determinant of its market value
capital ization.

Cost of uninsured CDs
Empirical support
Tests of some of the implications of this theory
are available in a Working Paper recently released by this Bank. The paper tests whether
banking organiZations With higher charter values
tend to hold more capital relative to assets and
have lower default risk than do banks with relatively low charter values using data from a sample of 85 large bank holding companies (BHCs)
over the period from 1971 to 1986.
In the paper, the value of a banking organization's charter is measured by the ratio of the
market to the book values of its assets, after
statistically controlling for a number of other
financial and economic factors that also influence market-to-book ratios. This is done to ensure that the variation in market-to-book ratios is
due to variation in charter value and not variation in variables that also could be related to
banking risk such as asset quality. The idea is that
the value of a BHC's charter will be capitalized
into its market value, but will not be reflected in
its recorded book value. This measure appears to
be a reasonable proxy for charter values since
market-to-book asset ratios are negatively and
statistically significantly related to the relaxation
of regulatory entry barriers, including liberalizing
branching and multi-bank holding company expansion laws. The trend in this measure suggests
that charter values have declined dramatically
since the early 1970s. Moreover, there is considerable variation in charter values across banking
organizations. This suggests that differences in
legislation and other factors influencing the competitiveness of local banking markets still exist.

There is considerable empirical evidence that
interest rates on uninsured deposits/such as
large (over $100,000) Certificates of Deposit
(CDs), contain a default risk premium. Banks that
are more likely to fail have to pay higher CD
rates. Presumably, banks with higher charter
values and therefore, greater incentive to limit
risk taking, should pay lower CD rates in general.
In fact, this study found that banks with higher
charter values do pay significantly lower rates on
CDs than do other banks.

The evidence on both capital-to-asset ratios and
the interest rates paid on CDs supports the notion
that valuable charters have limited risk taking,
despite the contrary incentives provided by the
deposit insurance system. Thus, at least some of
the increase in bank failures and payouts from
the FDIC may be due to a general decline in the
value of bank ch(1rters associated with increased
competition within the banking and financial
services industry.
In the past, the perverse incentives created by
the fixed-rate deposit insurance system were
countervailed by the potential loss of a valuable
charter that induced banks to limit their own risk
taking. This does not mean that it is desirable or
even possible to return to a system of anticompetitive restrictions in order to reduce banking
risk. But it does mean that we must now reform
our deposit insurance system and reduce the rewards it provides for excessive risk taking.

Michael C. Keeley
Research Officer

Market value capital ratios
As the theory predicts, there is a statistically
significant positive relationship between BHCs'

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 Boan;! of Governors of the Federal Reserve System.
Editorial comments may be addressed 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.


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