Abolishing Public Guarantees in the Absence of Market Discipline

RUHR ECONOMIC PAPERS Tobias Körner Isabel Schnabel Abolishing Public Guarantees in the Absence of Market Discipline #437 Imprint Ruhr Economic Papers Published by Ruhr-Universität Bochum (RUB), Department of Economics Universitätsstr. 150, 44801 Bochum, Germany Technische Universität Dortmund, Department of Economic and Social Sciences Vogelpothsweg 87, 44227 Dortmund, Germany Universität Duisburg-Essen, Department of Economics Universitätsstr. 12, 45117 Essen, Germany Rheinisch-Westfälisches Institut für Wirtschaftsforschung (RWI) Hohenzollernstr. 1-3, 45128 Essen, Germany Editors Prof. Dr. Thomas K. Bauer RUB, Department of Economics, Empirical Economics Phone: +49 (0) 234/3 22 83 41, e-mail: [email protected] Prof. Dr. Wolfgang Leininger Technische Universität Dortmund, Department of Economic and Social Sciences Economics – Microeconomics Phone: +49 (0) 231/7 55-3297, email: [email protected] Prof. Dr. Volker Clausen University of Duisburg-Essen, Department of Economics International Economics Phone: +49 (0) 201/1 83-3655, e-mail: [email protected] Prof. Dr. Christoph M. Schmidt RWI, Phone: +49 (0) 201/81 49-227, e-mail: [email protected] Editorial Offi ce Sabine Weiler RWI, Phone: +49 (0) 201/81 49-213, e-mail: [email protected] Ruhr Economic Papers #437 Responsible Editor: Christoph M. Schmidt All rights reserved. Bochum, Dortmund, Duisburg, Essen, Germany, 2013 ISSN 1864-4872 (online) – ISBN 978-3-86788-494-5 The working papers published in the Series constitute work in progress circulated to stimulate discussion and critical comments. Views expressed represent exclusively the authors’ own opinions and do not necessarily refl ect those of the editors. Ruhr Economic Papers #437 Tobias Körner and Isabel Schnabel Abolishing Public Guarantees in the Absence of Market Discipline Bibliografi sche Informationen der Deutschen Nationalbibliothek Die Deutsche Bibliothek verzeichnet diese Publikation in der deutschen National- bibliografi e; detaillierte bibliografi sche Daten sind im Internet über: http://dnb.d-nb.de abrufb ar. http://dx.doi.org/10.4419/86788494 ISSN 1864-4872 (online) ISBN 978-3-86788-494-5 Tobias Körner and Isabel Schnabel1 Abolishing Public Guarantees in the Absence of Market Discipline Abstract This paper shows that the abolition of state guarantees to publicly owned banks in Germany resulted in an increase in funding costs at German savings banks. Rather than being the result of increased market discipline, the increase in funding costs is shown to be driven by spillover eff ects from German Landesbanken who themselves had suff ered from the abolition of guarantees and who spread their own cost increase through the public banking network. Higher funding costs and the resulting drop in bank charter values translated into higher risk-taking at German savings bank. JEL Classifi cation: G21, G28, H11, L32. Keywords: Public bail-out guarantees; savings banks; Landesbanken; market discipline; bank risk-taking; banking networks August 2013 1 Tobias Körner, RGS Econ and Scientifi c Staff of the German Council of Economic Experts; Isabel Schnabel, Gutenberg School of Management and Economics, Johannes Gutenberg University, Mainz – We thank our discussants Tim Eisert and Christian Leuz, as well as Thomas Bauer, Daniel Baumgarten, Hendrik Hakenes, Alfredo Paloyo, Christoph Schmidt, and Hendrik Schmitz for their valuables comments and suggestions. We also benefi ted from comments by conference participants at the Max Planck Institute for Research on Collective Goods, the RGS Workshop at RWI Essen, the 1st Research Workshop in Financial Economics at JGU Mainz, the Ifo/CESifo/Bundesbank Conference on ‘The Banking Sector and the State’, the DFG Special Priority Program Conference ‘Financial Market Imperfections and Macroeconomic Performance’, and the Annual Meeting of the German Economic Association, as well as by seminar participants at the Universities of Bonn, Cologne, Mainz, and WHU Otto Beisheim School of Management, and the Joint Lunchtime Seminar (CFS/European Central Bank/Bundesbank). Tobias Körner gratefully acknowledges fi nancial support from the Leibniz Association through RGS Econ and from the Fazit foundation, Isabel Schnabel from the DFG Special Priority Program (SPP 1578) ‘Financial Market Imperfections and Macroeconomic Performance’. We also thank Deutscher Sparkassen- und Giroverband (DSGV) for insightful discussions. The opinions expressed in this paper refl ect the personal views of the authors and not necessarily those of the German Council of Economic Experts – All correspondence to: Isabel Schnabel, Gutenberg School of Management and Economics, Johannes Gutenberg University Mainz, 55099 Mainz, Germany, E-Mail: [email protected]. 1 Introduction In the recent financial crisis, large-scale bail-outs of banks occurred in all major banking systems. This raised expectations that banks, especially systemic ones, can rely on government support in times of crisis. Such bail-out expectations are a concern for policy makers and economists. They may reduce market discipline, give rise to excessive risk- taking and distort competition in the banking sector. However, the empirical effects of such guarantees are still not well understood because bail-out guarantees are hard to measure, especially if they are not explicit, but implicit (such as too-big-to-fail guarantees).1 In this paper, we try to shed more light on these issues by analyzing the effects of the abolishment of explicit public guarantees to publicly owned banks – savings banks and Landesbanken (state banks) – in Germany in the year 2001 (the Brussels agreement). Our paper focuses on the effect of the reform on German savings banks’ refinancing costs and risk-taking.2 Generally, the abolishment of public guarantees affects banks through two different channels. The immediate effect is an increase in funding costs, translating into lower margins and charter values. As high charter values tend to deter banks from taking excessive risks, risk-taking incentives increase when charter values drop (see Keeley, 1990; Hellmann, Murdock, and Stiglitz, 2000). However, there is a countervailing effect on risk- taking. In the absence of guarantees, bank creditors are no longer insulated from losses. Therefore, they become more responsive to the banks’ individual risk profiles. They exert market discipline by demanding higher risk premia or limiting banks’ access to external finance.3 Higher market discipline should reduce risk-taking incentives. The overall effect of an abolition of guarantees on banks’ risk-taking is thus ambiguous (see Cordella and Yeyati, 2003; Hakenes and Schnabel, 2010). We argue in this paper that these general predictions do not fully apply to German savings banks, who are part of a public banking network with a division of labor between 1An attempt to measure implicit guarantees was made by Gropp, Hakenes, and Schnabel (2011), who show that bail-out guarantees also distort risk-taking incentives of banks that are not protected by explicit or implicit government guarantees, but are standing in competition with protected banks. 2Two recent studies analyze the same policy experiment. Whereas Fischer, Hainz, Rocholl, and Steffen (2011) analyze the reaction of Landesbanken, Gropp, Gruendl, and Guettler (2011) focus on the reaction of savings banks, just as we do. Both papers are discussed in more detail below. 3Market discipline in banking has been analyzed, among others, by Flannery (1998), Flannery and Sorescu (1996), Sironi (2003), and Gropp, Vesala, and Vulpes (2006). 4 Landesbanken and savings banks. Whereas Landesbanken refinance largely through capital markets and act as central institutes in the public banking network, savings banks are locally operating retail banks. For a Landesbank refinancing in national and international capital markets, explicit government guarantees are reflected immediately in lower bond rates. In contrast, German savings banks rely mainly on customer deposit funding. As most depositors are insured by deposit protection schemes, an additional protection in the form of public guarantees is of minor importance and may not even be reflected in deposit rates. Therefore, it is far from clear why an abolition of guarantees should have a direct effect on savings banks’ funding costs. For the same reason, one would not expect an increase in market discipline. Hence, the direct consequences of the abolishment of public guarantees on savings banks are likely to be small. However, Landesbanken and savings banks are connected through lending relationships and ownership structures.4 Therefore, rising funding costs of Landesbanken after the abolition of guarantees may spill over to the corresponding savings banks. In this way, risk-taking incentives of retail banks are altered, too, although most of their creditors are not sensitive to the abolition of guarantees. While affecting refinancing conditions of savings banks, the market discipline exerted through this channel is likely to be small. Therefore, the indirect effects constitute a pure charter value effect, which - in theory - unambiguously increases risk-taking incentives of savings banks. We test this line of reasoning using a difference-in-differences approach. We first analyze the impact of the Brussels agreement on refinancing costs by comparing savings banks with a control group of German cooperative banks, who are similar to savings banks in terms of network structures but who were never subject to public guarantees. Then, to assess

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