Agency Problems in Banking: Types of and Incentives for Risk Shifting

Abstract

The banking literature has extensively examined risk shifting, especially in theoretical terms and in relation to the safety net and regulation. To set a framework of analysis for this moral hazard problem, we provide a brief synthesis of the incentive scheme underlying risk shifting. Then, we propose an empirical method to determine whether banks engage in risk shifting. This method also allows us, first, to classify risk shifting practices depending on the group of creditors to which shareholders transfer risk (that is, our method implies a taxonomy of risk shifting), and second, to identify positive and negative incentives for risk shifting. We apply our method to the banking systems of the United States and the European Union and discuss the resulting findings.

Appendix. Definitions of Variables

• Capital-to-assets ratio (CR): $\frac{\mathrm{C}}{\mathrm{A}}$.

• Deposits-to-assets ratio (DR): $\frac{\mathrm{D}}{\mathrm{A}}$.

• Ratio of non-depository debt to assets (NDR): $\frac{\mathrm{ND}}{\mathrm{A}}$.

• Risk-weighted assets to total assets ratio (RWAR): $\frac{\mathrm{RWA}}{\mathrm{A}}$.

• Additive inverse of Z-Score (ZS): $- \frac{\mathrm{CR}+\mathrm{R}\mathrm{O}\mathrm{A}}{\upsigma^{\mathrm{ROA}}}$.

• Size (SIZ): ln A.

• Profitability (PROF): $\mathrm{R}\mathrm{O}\mathrm{A}=\frac{\mathrm{NI}}{\mathrm{A}}$.

• Capital buffer (BUF): $\mathrm{C}\mathrm{R}-\mathrm{R}\mathrm{C}\mathrm{R}$.¹³

• Generosity of deposit insurance scheme (DI): To build this index, we follow Demirgüç-Kunt and Detragiache (2002). See also Duran and Lozano-Vivas (2014, 2015). The index is increasing in the generosity of the deposit insurance scheme.

• Strictness of restrictions on bank activities (REST): To build this index, we follow Barth et al. (2001, 2008). The index is increasing in the strictness of the restrictions on bank activities.

• Strictness of capital requirements (CAP): As regards the method to build this index and its properties, see REST above.

• Strictness of supervision (SUPERV): As regards the method to build this index and its properties, see REST above.

• Strictness of market discipline (MKDISC): As regards the method to build this index and its properties, see REST above.

A :

Total assets

C :

Equity

D :

Deposits

ND :

Non-depository debt

NI :

Net income

RCR :

Regulatory capital-to-assets ratio

ROA :

See profitability above

RWA :

Risk-weighted assets

σ ^ROA :

Standard deviation of ROA