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FRBSF

WEEKLY LETTER

March 25, 1988

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 "primary 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 third quarter 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 regulatory policy. The bank regulatory authorities
began to place more emphasis on capital regulation in the early 1980s, starting with an
announcement in 1981 of the first explicit minimum 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 requirements have made minimum capital standards
more or less uniform for all banking organizations 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 adequacy have not kept pace with possible
increases in asset risk.
Greater asset risk
One of the regulators' worries has been the relative decline in banks' holdings of low-risk, liquid
assets, such as Treasury and agency securities.
Another concern is the growing volume of problem 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
qual ity of bank asset portfolios has deteriorated.
Finance theory suggests a more comprehensive
measure of asset risk: the variation of the economic 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 deviation, 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 measure can be estimated using information on the
standard deviation of the rate-of-return on the
share prices of a bank holding company's common equity. The simplest approach is to approximate the asset-return standard deviation as the
standard deviation of the 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 liabilities 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 of the 1970s. This rise in asset risk in
the 1980s is statistically significant.

Insurance system risk
A central policy question, and the primary concern 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 holding companies. A related concern is whether, on
balance, the risk exposure of the deposit insurance system has increased.
Robert Merton has provided a convenient framework for such an inquiry. He has shown that the
value of the 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 of leverage of a banking
institution and the standard deviation of the economic 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 guarantee 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 calculations, 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 caution, 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 reference, the maximum statutory deposit insurance
premium is about eight cents per $100 of
deposits. The chart shows a large and statistically 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 capital position among the sample of large BHCs
has become weaker, not stronger. An appropriate 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 consequence 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 discussed 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 incentives

Chart 1
Primary Capital to
Total Assets

Percent

8

Chart 3
Mean Value of
Deposit Insurance

Cents
per $100
of Deposits

16

7

6

5

:0"

'.

4

.............
:......

V· .". . .

77

79

81

3
83

85

87

Chart 2
Asset Risk

* Significant

Standard Deviation of
Return on Market
Value Assets

0.8

at the 95 percent
level of confidence.

0.7
0.6
0.5
0.4
0.3

76

78

80

82

84

86

for risk-taking increase in response to higher regulatory capital requirements, then the effect
should be most evident among the "under-capitalized" 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 beginning of the decade, despite the increases in capital to assetratios. The deterioration in the
effective capital positions among the large BHCs
argues for vigorous regulatory efforts to raise further 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 of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the 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.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Amount
Outstanding

3/02/88

Change from 3/04/87
Dollar
Percent?

Change
from

2/24/88

204,425
180,866
51,523
70,834
36,107
5,761
16,519
7,041
204,304
50,477
33,793
20,513
133,314

-

-

1,146
2,310
751
4,295
3,764
394
3,277
180
1,496
2,556
1,136
914
146

-

-

-

0.5
1.2
1.4
6.4
9.4
7.3
24.7
2.6
0.7
- 4.8
3.2
4.6
0.1

-

-

2,254

-

4.9

72
446

-

1,064
5,969

-

3.3
21.6

Period ended

Period ended

2/22/88

2/8/88

Reserve Position, All Reporting Banks
Excess Reserves (+ )lDeficiency (- )
Borrowings
Net free reserves (+ )lNet borrowed( -)
1
2

3
4

S
6
7

28
6
22

98
9

90

Includes loss reserves, unearned income, excludes interbank loans
Excl udes trad ing accou nt secu rities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annual ized percent change

j

-

84

43,275
30,542
21,557

960
758
494
83
77
20
224
22
3,998
3,271
1,207
607
120