Regulatory Forbearance and Depositor Market Discipline: Evidence from Savings Banks in Korea

I. INTRODUCTION Market discipline constrains the risk-taking behavior of banks and thus has the potential to. help reduce the probability of bank failures and minimize the cost of failures that do occur. Bank regulators' forbearance practices have been criticized for causing market discipline to fail in more than a few cases. For example, since the late 1980s, the unprecedented. losses resulting from bank failures have provoked serious criticism of regulatory forbearance that allows insolvent banks to continue their operations. This criticism is based largely on the proposition that banks have a greater incentive to gamble with deposit insurance funds when the likelihood of forbearance is greater (Nagarajan and Sealey 1995). Some studies analyzing financial crises designate the lack of market discipline or a poor regulatory environment as a cause of the crises and emphasize the enhancement of market discipline to prevent financial crises (Kaufman 2000; Yoon and Miller 2004). This study attempts to examine the effect of forbearance on depositors' market discipline. To find evidence that regulatory forbearance diminishes market discipline, we empirically test whether the sensitivity of the deposit growth rate and uninsured deposit ratio to bank risks are affected by regulatory forbearance. We examine not only the depositors of the banks subject to forbearance but also those of neighboring banks. The laboratory of our study is a set of savings banks in Korea and the study period is 2000-2010. Considering the regulatory environment of savings banks, we believe that Korea's savings bank industry provides a good opportunity to test our hypotheses. This paper is related to Brown and Dinc (2011) documenting the too-many-to-fail channel of regulatory forbearance in that our sample period is characterized by a series of exits of savings banks resulting from the restructuring plan of the Korean regulatory authority. (1) We find that the sensitivity of depositors to banks' non-sound asset ratios significantly decreases when regulatory forbearance is apparent. This negative effect of forbearance is observed not only in the banks subject to forbearance but also in neighboring banks in the same business region. If depositors believe that a regulator does not intend to close a bank in the foreseeable future, they will not withdraw their deposits, even though the bank risks are at a substantially high level. In other words, depositors prefer enjoying the high-interest income provided by failing banks to withdrawing their funds from those banks, as long as they believe that enough time remains to withdraw their deposits before the bank is closed by the regulator's order. This depositor behavior should be more evident in circumstances where bank failures are triggered mainly by regulators' closure decisions, not by depositors' runs. In this situation, deposit decisions may rely more on bank regulators' intentions than on available bank risk information. On the basis of these findings, we suggest that savings banks' risk information be more accurately disclosed, especially through the regulator's supervisory measures. Otherwise, regulatory forbearance may cause an increase in the expected cost of bank failure due to depositors' loose discipline with regard to bank risks. The contribution of this paper stems from the literature's excessive focus on U.S. data since the early 1990s. Evidence from another country, one that is sufficiently different from the United States to offer another data point but not so different as to make that data point difficult to interpret, could bring into sharp relief the key factors necessary to make market discipline an effective contributor to the supervisory process. Such evidence is particularly important in light of the market-discipline pillar in Basel IL which is applied internationally. (2) To this end, we scrutinize depositor behavior in country-specific circumstances where there is a high possibility of regulatory forbearance. …