Silviase/jgov_v1.4_full_ann huggingface dataset:
2.2 “Big Bang” Reform to Phase in Open Competition

After the breakdown of the convoy system, hopes for a disciplinary role among depositors mounted in Japan. Depositors are not entitled to any special benefits, even if a bank’s high-risk investments succeed, while they will suffer some portion of losses in case of failure. Therefore, depositors have incentives to curb the risk-taking activities of banks, and their option to shift deposits from risky banks to safer ones may be able to perform a disciplinary role.

Following the announcement of Japan’s “big bang” reform in 1996 to phase in open competition, Japanese authorities took a sequence of actions to establish a new framework that emphasizes the disciplinary function of depositors. Those actions included: strict enforcement of bank capital standards, enhancement of public disclosure, prompt closing of inferior banks, a move toward limited deposit insurance, and other schemes that utilize market forces. Since the success of the new framework partly rests on the presence of depositor sensitivity to bank risks, empirical verification of their critical eye is essential to Japanese policy design.

3. Data and Methodology

3.1 Data

Our data sources are Nikkei Financial Data CD-ROM for Banks, Financial Statements
of Shinkin Banks in Japan, and Financial Statements of Credit Cooperatives in Japan, the last two of which are edited by Financial Book Consultants, Ltd. (Kinyu tosho konsarutanto sha).

The sample institutions are composed of city banks, first and second regional banks, shinkin banks, and credit cooperatives. Although we exclude trust banks, long-term credit banks, and labor banks, our sample occupies close to 95 percent of all insured financial institutions (or 90 percent of total insured deposits) in Japan, comprising the largest-ever coverage on Japanese financial deposit-taking institutions. We use unbalanced panel data from March 1992 to March 2003.

To improve the reliability of our analyses, we made the following cuts. First, for the

institutions that failed, we deleted the observations in the previous year of the incidents. This is

because those data are not necessarily available for all the failed institutions, and also because the

deposit rates (calculated as interest expenses divided by interest paying debt) immediately before the

failure are less reliable due to discrete changes of related variables. Second, if an institution was

involved in a merger with another bank, or acquired the business of a failed institution, we excluded

it from our sample for that year. For credit cooperatives, we include regional ones only, since other

types of credit cooperatives may have their own behavioral principles other than economic ones. $ ^{4} $

These selections leave us with a sample of 788 institutions (10 city banks, 62 first regional banks, 65
second regional banks, 426 shinkin banks, and 225 credit cooperatives) in FY1992 to 462 in FY2002. Total bank-year sample consists of roughly 7,400, the largest dataset on deposit-taking institutions ever studied in Japan.

### 3.2 Methodology and Bank Fundamental Variables

To examine the ability of depositors to tell banks apart and their sensitivity to bank

risks, we look at the effect of deposit-taking institutions both on deposit growth and interest rates. As it is readily verified in the followings, we can distinguish depositor behavior from bank behavior by analyzing both of the two variables. $ ^{5} $

Consider the following simple two-equation structural model of deposit market:

$$ Deposit_{i,t}=a_{0,i}+a_{1}Interest_{i,t}+a_{2}Fundamentals_{i,t-1}+\sum_{k=1}^{n}a_{3,k}X(k)_{i,t}+\boldsymbol{\varepsilon}_{it} $$

$$ Deposit_{_{i,t}}=b_{_{0,i}}+b_{_{1}}Interest_{_{i,t}}+b_{_{2}}Fundamentals_{_{i,t-1}}+\sum_{k=1}^{n}b_{_{3,k}}X\left(k\right)_{_{i,t}}+\mathsf{\mu}_{_{it}} $$

where the first equation represents supply of deposits by banks, and the second represents

demand for deposits by depositors, respectively. Interest $ _{i,t} $ is the interest rate on deposits of
institution i in year t, $ Fundamentals_{i,t-1} $ represents a bank fundamental variable that takes

higher value when institution i is in good shape in year t-1, $ X(k)_{i,t} $ is an exogenous control variable k, and $ \varepsilon_{it} $ and $ \mu_{it} $ are disturbances. Since our main interest is in depositor sensitivity to bank risks, we want to confirm the fact that depositors shifted their deposits from risky banks to safer banks, i.e. $ b_{2} > 0 $ . To avoid the simultaneity bias, we run the following two reduced form regressions, derived from the equations (1) and (2) above:

$$ Deposit_{_{i,t}}=\mathsf{\mu}_{_{i}}+d_{_{t}}+\mathsf{\alpha}Fundamenta\ l s_{_{i,t-1}}+\sum_{k=1}^{n}\mathsf{\gamma}_{_{k}}X\left(k\right)_{_{i,t}}+\mathsf{\cup}_{_{it}} $$

$$ I n t e r e s t_{_{i,t}}=\boldsymbol{\varphi}_{_{i}}+k_{_{t}}+\boldsymbol{\beta}F u n d a m e n t a l s_{_{i,t-1}}+\sum_{k=1}^{n}\boldsymbol{\varphi}_{_{k}}X\left(k\right)_{_{i,t}}+\boldsymbol{\omega}_{_{it}} $$

$$ where\ \mathsf{\alpha}=\frac{a_{1}b_{2}-b_{1}a_{2}}{a_{1}-b_{1}},\ \beta=\frac{b_{2}-a_{2}}{a_{1}-b_{1}},\ \forall_{k}=\frac{a_{1}b_{3,k}-b_{1}a_{3,k}}{a_{1}-b_{1}},\ and\ \boldsymbol{\varphi}_{k}=\frac{b_{3,k}-a_{3,k}}{a_{1}-b_{1}}. $$

Assuming normal market conditions for deposits, we could expect $ a_{1}<0 $ and $ b_{1}>0^{6} $ . If we additionally assume $ a_{2}\leq0 $ , a positive coefficient on the bank fundamental variable in equation (3), i.e. a>0, ensures $ b_{2}>0 $ . However, if the possibility that $ a_{2}>0 $ exists, we cannot determine the sign of coefficient $ b_{2} $ only from the $ \alpha $ estimate. In fact, risky Japanese
banks in 1990s are said to have been forced to reduce their assets to comply with regulatory

capital standards and to cause a positive correlation between bank fundamentals and deposits,

i.e. $ a_{2}>0 $ . Under such situations, the reduced form coefficient $ \alpha $ may turn positive even if

$ b_{2}\leq0 $ contrary to our expectations of depositor discipline. Therefore, to confirm $ b_{2}>0 $ from

the reduced form regressions, we have to make use not only of $ \alpha $ but also of $ \beta $ . As is easily

verified, the combination of $ \alpha>0 $ and $ \beta<0 $ is a sufficient condition for risk-sensitive bank

depositors $ (b_{2}>0)^{7} $ .

As our Fundamenta $ ls_{i,t-1} $ , we tried two variables that are reported to have significant connections with depositor bank selection in Murata and Hori (2005). The first variable is a capital-asset ratio $ ^{8} $ , which is defined as the ratio of own capital to total assets. The capital-asset ratio represents the bank’s asset risks, and it occupies the interest of the general public in Japan as an indicator of bank health, especially after the introduction of the Basel capital standard in March 1993. If depositors are concerned about bank risks and responding rationally to the potential risks, we expect the capital ratio to have a positive effect on deposits and a negative effect on deposit interest rates. The second variable is bank profitability, which is measured by the ratio of operational profits to total assets. Since high profitability is directly connected with

$$ b_{_{2}}-a_{_{2}}>0 $$

$$ a_{,}>0 $$

$$ b_{,}>a_{,}>0 $$

$$ a_{2}\leq0 $$

$$ b_{2}>b_{1}a_{2}/a_{1}\geq0 $$
bank strength, we expect this profitability variable also to have a positive influence on deposit growth and a negative effect on deposit interest rates.

As one of our control variables $ X(k)_{i,t} $ , we include the logarithm of total assets as a size proxy. Since trust remained in the “too-big-to-fail” commitment up until the Hokkaido Takushoku Bank (HTB) failure in November 1997, the size proxy should have some influence on deposit shifts among institutions. We also included changes in postal savings by prefectures, changes in the ratio of working-age population to total population by prefecture, and the average lending rates of financial institutions by prefecture as our control variables in the reduced form regressions with fixed effects and year dummies.

Table 3 reports the summary statistics of our dataset: Table 3-1 summarizes all

samples used in this paper, and Tables 3-2, 3-3, and 3-4 summarize the data by three

institutional categories, i.e., international operation banks, domestic operation banks, and

Shinkin banks and credit cooperatives. The first four rows of each table give us scale

information for the institutions (in billions of yen), and the lower six rows summarize the

statistics for the variables included in our regression analyses below.
### 4. Empirical Results

### 4.1 Basic Results

To study the effects of bank characteristics on depositor behavior, we run the reduced-form regressions (3) and (4) above. To take account of possible idiosyncrasies of each institution, we report the result of panel regressions (within estimates) for the period from FY1992 to FY2002.

The first four columns of Table 4 report the regression results of the deposit growth equation and the deposit rate equation, with the capital-asset ratio (column [1] and [2]) or with the profit ratio (column [3] and [4]) as our Fundamenta $ ls_{i,t-1} $ variable. For both fundamental variables, the estimated coefficient in the deposit growth regression is significant positive ( $ \alpha>0 $ ) and that in the deposit rate regression is significant negative ( $ \beta<0 $ ). As described in the previous section, combination of $ \alpha>0 $ and $ \beta<0 $ is a sufficient condition for the presence of the risk-sensitive depositors. Therefore, the results clearly show a basis of depositor discipline exists in the Japanese deposit market over the estimation period from FY1992 to FY2002.

The parameters on logarithm of total assets represent mixed results. The negative coefficients in the interest rate equations suggest that depositors require higher interest rates to

smaller banks, which is consistent with the trust in “too-big-to-fail” commitment. On the other hand, the coefficients in the deposit growth equations have a negative sign, implying that
depositors prefer to put their deposits in smaller banks. The coefficients on changes in log of postal savings by prefecture have a positive sign, contrary to our expectation, but not statistically significant.

### 4.2 Results with Parameter Shift Dummies

Having seen the presence of the risk-sensitive depositors—a necessary condition for satisfactory depositor discipline on banks, throughout the period examined—we next try dummy variables that allow for parameter shifts over the years. Previous studies all agree in reporting that depositor sensitivity to bank risks in Japan changed over time, complying with the historical developments. We selected FY1995 (March 1996), FY1999 (March 2000), FY2001 (March 2002) and FY2002 (March 2003) as our timings of the potential parameter shifts, following Hori and Murata (2005).

The jargon “pay-off” started to appear in the Japanese major newspapers after the mid

1990s, and two large credit cooperatives (Cosmo and Kizu), along with Hyogo Bank, failed in

FY1995. The second timing of parameter shifts (March 1999) is the month one year before the

scheduled closing day of the blanket guarantee. $ ^{9} $ The third timing (March 2002) is the month

just before the reintroduction of pay-off to time deposits in Japan. It is during these three
timings that we are supposed to observe intensified preferences for healthier institutions. On the other hand, the last selection (March 2003) allows us to observe a relaxation of depositor discipline. In FY2002, the Japanese government announced the postponement of payoff reintroduction to demand deposits, $ ^{10} $ and introduced newly defined deposits with full protection.

Columns five to eight of Table 4 report the results with those structural change shifts.

dummies. Two out of four estimated coefficients on the basic variables, which correspond to the observations until FY1994, turn their signs and lose their statistical significance after the inclusion of the shift dummies, suggesting relatively weak discipline until the mid 1990s. The coefficients on newly added shift dummies, now, make up for the lost explanatory power of the fundamental variables tracking the changes in depositor sensitivity to bank risks over time. The coefficients on the capital ratio in the deposit growth equation increased incrementally until FY2001, and decreased in FY2002, as expected. Together with the coefficients in the interest rate equation, which turn negative after FY1995, estimated parameter shifts show that depositors intensified and relaxed their sensitivity to the capital ratio, in compliance with the historical developments of regulatory schemes. Coefficients on the profit ratio (in columns [7] and [8]) also confirm the changes of risk sensitivity, in consonance with the times. The
coefficient in the deposit growth equation turns positive in FY1995 and continues to increase until the setback in FY2002. Though the profit rate coefficients in the deposit rate equation moves irregularly, their sums are consistently positive, ensuring positive $ b_{2} $ in the demand equation (2) for deposits.

It may not be clear why the coefficients on capital asset ratio and profitability in the interest rate equations increased in 1999FY. One possible explanation consistent with our orderly depositors is that $ a_{2} $ in equation (1) becomes larger in 1999FY, implying that risky banks made their deposit rate lower to reduce their deposit for the purpose of satisfying the BIS standard on capital ratio.

### 4.3 Comparison Among Heterogeneous Institution

One notable advantage of the large dataset we use in this study is its coverage of heterogeneous institutions, i.e. city banks, regional banks, shinkin banks and credit cooperatives. Having confirmed the presence of risk sensitive depositors and transitions of their sensitivities to accommodate the institutional developments over years, we proceed to examine the difference of depositor responses among types of institutions.

As reported in Table 3 average size of banks and cooperatives (shinkin banks and

credit cooperatives) are substantially different; they are based on fairly different foundations,
and are subject to different regulations. Among others, depositors to cooperatives are mostly

individuals or small and medium enterprises (SMEs) that are supposed not to have expertise in

evaluating the risk of bank failures. $ ^{11} $ In addition, since deposits at cooperatives or smaller

institutions tend to add up to small amounts—i.e., less than the maximum insurance payments

per depositor (¥10 million + interest)—the ratio of deposits fully protected by deposit insurance

is presumed to be high. $ ^{12} $ Therefore, depositors of smaller institutions may be less-sensitive to

the risk of bank failures, and their responses reflect the financial literacy of small-account

depositors and the importance of non-pecuniary restitution costs in bank selection. On the other

hand, the responses of depositors to larger institutions reflect the sensitivity of large-account

depositors who are subject to the payoff risks, and who are supposed to have some expertise in

bank evaluation.

The first four columns of Table 5 report regression results with dummy variables that allow for parameter differences among institutions of different types. We divide the sample institutions into three categories: i) international banks, ii) domestic banks, and iii) deposit-taking cooperatives, i.e. shinkin banks and credit cooperatives $ ^{13} $ that operate
domestically. We then compared the coefficients using the second category, i.e. domestic banks,

as our base.

The signs on the baseline coefficients, which correspond to the behavior of regional

bank depositors, decisively prove the presence of disciplinary depositors. However, what's more

interesting is the pattern of coefficients on interaction terms for other categories. The parameter

shifts observed on the institution dummies, i.e. the international bank dummy and the

cooperative dummy, are generally consistent with our inferences. Probably reflecting the

different shares of large-account depositors, who are relatively well-informed and subject to

higher payoff risks, in each category the coefficients on the two key fundamental variables, i.e.

capital ratio and profit ratio, are larger for the international banks and smaller for the

cooperatives in the deposit growth regressions, hinting at more risk-sensitive depositors at larger

institutions, as expected. Although the observed patterns of coefficients in the deposit rate

equations are not necessarily clear-cut, coefficients on the capital ratio are consistently negative,

ensuring depositor rational responses to the ratio.

The right half (column [5] to [8]) of Table 5 reports results that incorporate parameter

shifts both over time and over institution type. Although we do not provide detailed descriptions

due to space limitations, the estimated coefficients for each category are generally consistent

with the pattern inferred from the standard banking theory.
### 4.4 Identification Restriction and Quantitative Evaluation

The qualitative arguments (on the signs of the coefficients) in the previous section hold up well without any identifying restrictions in the structural equations. However, with proper restrictions, we may be able to identify the coefficients in question, i.e. $ b_{2} $ , quantitatively. Let us suppose that one of the coefficients on the control variables, for example $ b_{3,1} $ , is naturally assumed to be zero in equation (2). Then we can calculate the structural parameter $ b_{2} $ using the reduced form coefficients as $ b_{2} = \alpha - b_{1}\beta = \alpha - (\gamma_{1}/\phi_{1})\beta $ .

Among the control variables in our regression model, a parameter restriction on the

lending rate term is probably the most convincing. Although high lending rates surely urge banks to supply more deposits, we have no ground for believing that the rates directly affect the demand for deposits by depositors. Therefore, from the reduced form parameter estimates, we can calculate $ b_{1} $ through $ b_{1} = \gamma_{1} / \phi_{1} $ , i.e. 1.8581 / 0.2342 = 7.933 and derive structural parameter $ b_{2} $ is 0.929 for the basic result with capital ratio regressions. Detailed results on models with the parameter shift dummies are shown in Table 6.

Of course, the qualitative natures of derived $ b_{2} $ s are not different from those of

previous sections. More informatively, derived structural parameters indicate that estimated $ b_{2} $ s

are positive for all cases, regardless of some positive coefficients on profit ratio terms observed
in the deposit rate regressions. This indicates that Japanese depositors consistently appreciated

the difference between healthy banks and risky banks. The ordering of the parameter size,

especially on the capital asset ratio, is also in line with our theoretical conjectures: derived

coefficients on the fundamental variables are large for international banks and small for

cooperatives $ ^{14} $ , and they continue to increase until the setback in FY2002, keeping step with the

changes of institutional settings.

Finally, the most notable finding from the derived structural parameters ( $ b_{2,j} $ s) is their quantitative magnitude. Taking an example of the capital ratio parameter, estimated elasticity for the international banks indicates that, if a capital asset ratio of a certain bank falls by one percentage point, the annual growth of demand for deposits in the bank declines by two to three percent. The elasticity for the domestic banks is roughly about one and that for the deposit-taking cooperatives is a smaller, but still tangible, 0.8. Observed diverse elasticity among institutions of different types indicates that deposit-taking institutions are exposed to some market pressure, even without the payoff risks of limited coverage, though the pressure is modest by any definition. When depositors are subject to a significant payoff risk, they become sensitive to bank fundamentals and probably exercise disciplinary power that complements the
regulation by the authorities.

### 6. Conclusion

This paper empirically investigated the issues of depositor discipline by examining Japanese deposit-taking institutions since the 1990s. We are concerned with two questions that are relevant to the design of a new regulatory framework for Japanese banking: 1) whether depositors respond to bank risks as standard theories expect, and, if they do, 2) whether the responsiveness is significant enough to discipline deposit-taking institutions. To address these issues, we set up a dataset that covers close to 95 percent of all insured financial institutions in Japan, and examined the differences in depositor risk sensitivity among types of deposit-taking institutions, as well as the transitions over the sample period from FY1992 to FY2003.

The results obtained in this paper show that Japanese depositors rightly responded to the risks of financial institutions as predicted by standard arguments. Observed risk sensitivities rose during FY1995, FY1999, and FY2001, and fell during FY2003. The first shift is associated with the failures of Hyogo Bank and the two large credit cooperatives. The second and third shifts suggest that depositors acted on that timing in anticipation of the reintroduction of a "pay-off" scheme, and the setback in FY2002 implies that depositors slack off their discipline in face of the postponement of the payoff reintroduction. Ordering of the parameter size among
types of institutions also confirms our theoretical conjectures: that risk sensitivities are larger for international bank depositors and smaller for cooperative depositors. The derived structural parameters on the bank fundamentals in deposit demand equation, especially those for international banks, are large enough to discipline the deposit-taking institutions.

The findings of this paper clearly show that Japanese depositors have a disciplinary nature, and that their behaviors are affected by changes in regulatory frameworks, especially those of deposit insurance. It is, therefore, important for policy-makers to design financial systems (and safety nets) so as to make the best use of the discipline imposed by depositors on the banking institutions.
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