Silviase/jgov_v1.4_full_ann huggingface dataset:
must establish a new regulatory framework. After the breakdown, hopes for the disciplinary function of depositors mounted in Japan. Depositors (as a type of creditor) are not entitled to any special benefits, even if a bank’s high-risk investment succeeds, while they will suffer some portion of the losses in case of failures. Therefore, depositors have strong incentives to curb banks’ risk-taking activities. Although regulatory authorities monitor banks to represent the interests of small-account depositors, who are not experts in bank monitoring, depositors’ option to shift their deposits from risky banks to safer banks (“bank selection”) may be able to perform a disciplinary role by means of “exit” as defined by Hirschman (1970).

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, use of prompt corrective action, closing of inferior banks, a move toward a limited deposit insurance system, and other schemes that utilize market forces. Since the success of the new framework rests on the presence of depositor discipline, empirical verification of the discipline is essential to Japanese policy design.

### 2.3 Development of a Deposit Insurance System

The end of the convoy system also highlighted the importance of deposit insurance. Though Japanese deposit insurance was established in 1971, it remained nonfunctional until 1992. As the banking problems became apparent to the public in the mid-1990s, the Japanese government declared in 1995 an introduction of a blanket guarantee that protected unlimited amount of deposits as an emergency measure.

Though the blanket guarantee was initially scheduled for March 2001, the lift of the emergency measures was postponed in 1999 until March 2002. In April 2002, the authorities reintroduced the ¥10 million maximum insurance payments for time deposits; on the other hand, it decided to continue unlimited protection for demand deposits until March 2005. Finally, in December 2002, the authorities decided to introduce “payment and settlement deposits,” which are redeemable on demand and bear no interest, to be fully and permanently protected after April 2005. These bustling changes in the deposit insurance may be undesirable in terms of policy transparency, but they offer us a rich opportunity to examine how the changes in the design of deposit insurance affect depositor disciplinary behavior.

### 3. Data and Methodology
### 3.1 Data

Our main data source is Financial Statements of Shinkin Banks in Japan and Financial Statements of Credit Cooperatives in Japan, both of which are edited and published annually by Financial Book Consultants, Ltd. (Kinyu tosho konsarutanto sha). We use unbalanced panel data from March 1992 to March 2003. The sample covers the period when the collapse of asset bubbles put Japan’s banking system on very shaky ground. Japan’s financial system was reformed from its convoy style to a market-based self-responsibility style. Moreover, the Basel capital standards were enforced, and the deposit insurance scheme was amended a number of times.

To improve the reliability of our analyses, we made the following cuts. First, we delete bank observations that failed less than two years after their statements of accounts. 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 observed regional ones only, since other types of credit cooperatives may have their own behavioral principles other than economic ones $ ^{8} $ . These selections leave us with a sample of 648 institutions (418 shinkin banks and 230 credit cooperatives) in 1992 to 410 (297 and 113) in 2002. Total bank-year sample consists of roughly 5,500, the largest data set on deposit-taking institutions ever studied in Japan.

### 3.2 Variables and Regression Model

To examine depositor behavior, we look at the effect of characteristics of deposit-taking institutions on deposit growth $ ^{9} $ . Although small-account depositors may be incapable of effective monitoring due to the free-rider problem, they have the option to shift deposits from risky banks to safer banks if they perceive possible bank failures. Thus, the variables that reflect the risk of the failure of each institution are assumed to have negative effects on deposit growth. In the basic model of our regression analyses below, we use the annual growth of total deposits for each institution as our dependent variable.

$$ \Delta ln Deposits_{i}=\alpha+\beta Bank fundamentals_{i}+e_{i}. $$

As bank fundamentals, we test five variables that probably have some connections with the
risk of bank failures. The first variable is a capital-asset ratio, 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 $ ^{10} $ . If depositors are very much concerned about bank risks and are exerting a disciplinary function, we can expect a positive correlation between the capital ratio and deposit growth.

The second explanatory variable is the share of real-estate-related loans defined as the ratio of real-estate-related loans to total outstanding loans. As Japan’s banking problems emerged after the burst of the asset bubble, loans to real-estate related industries that were not profitable for more than ten years are a synonym for low-quality credit in Japan. Risk-conscious depositors would prefer to keep their bank account in the institutions with smaller real-estate loans. Therefore, we expect the real-estate share variable to have a negative impact on deposit growth.

The third explanatory variable is an indicator of banks' liquidity risks, which is defined as the ratio of cash, deposits (to other banks) and government bonds to total assets. Banks with large liquid assets are perceived to be safer, since these assets would allow a bank to meet unexpected withdrawals. We expect this variable to have a positive effect on deposit growth. The fourth explanatory variable is bank profitability, which is measured by the ratio of operational profits to total assets. After controlling for the balance sheet conditions such as the capital ratio and the real-estate share, we expect this profitability variable to have a positive influence on deposit growth.

The last variable is a proxy for bank size. At least up until the failure of the Hokkaido Takushoku Bank in November 1997, the Japanese public believed the government would stick to the “too-big-to-fail” commitment. In consideration of the forbearance policy (especially for larger banks) by the government, depositors may prefer to have their accounts in larger institutions. We use the logarithm of total assets as the size proxy. We expect a positive correlation between the bank size proxy and deposit growth for risk-conscious depositors.

The summary statistics of our data can be seen in Table 4. The first four rows of the table give us scale information for the institutions (billions of yen), and the lower rows summarize the statistics for the variables included in our regression analyses below.

### 4. Empirical Results

4.1 The Effect of Bank Risk Characteristics on Deposit Growth
Table 5 presents results of our cross-section regressions for each year from FY 1992 to FY 2001 (March 1993-March 2002). The sample consists of shinkin banks and credit cooperatives; the table reports the results for the total sample (shinkin banks & credit cooperatives), shinkin sample, and credit cooperative sample respectively. Since the results for each bank type are not very different, we illustrate the results for the total sample in our main text.

#### 4.1.1 Cross-section Regressions for Each Year

Signs of the estimated coefficients are generally consistent with our expectations for disciplined depositors, i.e., positive on the capital asset ratio, negative on the real-estate-related loan share, positive on the liquid asset ratio, positive on the profit ratio, and positive on the bank size proxy; a comparison among fiscal years makes the working of market discipline much clearer.

Although the coefficients on the capital-asset ratio are all positive throughout the years examined—indicating depositor concern for the ratio—those are relatively small and statistically insignificant up until FY 1995. It turns significant in FY 1996 for the first time, and increased in size after FY 1997 (March 1998), directly after the systemic banking crisis in 1997-98. One natural interpretation of this transition is that depositors became capital conscious through the introduction of Basel capital standard and the experience of the banking crisis.

The results on the share of real-estate-related loans are a bit mixed. Estimated coefficients for earlier years are positive, contrary to our expectations. However, they turn to negative after FY 1998 and become significant toward the end. The idea that the share of real-estate-related loans reflects the quality of an institution’s assets is relatively new. Changes in the real-estate share coefficients seem to suggest that depositors were not concerned with the real-estate share until recently; however, they began to take interest in that share through the lasting asset price deflation that eroded the collateral value of bank loans throughout the 1990s. The coefficients on the ratio of liquid assets to total assets often turn negative inconsistently with our expectation, though they are not statistically significant.

Estimated coefficients on bank profitability are all positive throughout years, and the majority of them are statistically significant. This seems to suggest that Japanese depositors had a marginal sense to prefer profitable banks even before the collapse of the traditional convoy system.

The transition pattern of the bank size coefficients also rouses our interest. Significantly positive coefficients until FY 1996 indicate that Japanese depositors preferred to put their money in larger institutions, irrespective of the fact that the too-big-to-fail policy does not apply to shinkin banks and credit cooperatives. However, the love for larger banks has been relinquished (the coefficients turn to small and insignificant) in FY 1997, when the failures of Yamaichi Securities and Hokkaido Takushoku Bank signified the end of the too-big-to-fail policy.
#### 4.1.2 Panel Regressions

Although the results above are quite suggestive of the working of market discipline, the results of the cross-section regression may be biased due to some unobserved individual effects. Here, we report the results of panel regressions (within estimates $ ^{11} $ ) for the period from FY1992 to FY2001 that take account of the possible idiosyncrasies of each institution. Equation (1) is now replaced with the following:

$$ \Delta ln Deposits_{i,t}=\upmu_{i}+d_{t}+\beta Bank fundamentals_{i,t-1}+e_{i,t}. $$

where $ d_{t} $ represents time specific effects and $ \mu_{i} $ individual or fixed effects.

The first column of Table 6 shows that the depositor discipline observed in our cross-section analyses is generally verifiable by a panel regression. Although the bank size coefficient turns to negative, contradicting our reliance on the too-big-to-fail policy, the coefficients on the capital asset ratio and profitability are still significantly positive, indicating the disciplinary behavior of Japanese small-account depositors.

To take account of the changes in the behavioral characteristics of depositors, we tried several dummy variables that allow for parameter shifts over the years. Based on the results of F-tests to detect the timings of parameter shifts, we select FY1995 (March 1996) and FY1999 (March 2000) as our points of structural change examinations. The second column of the Table 6 reports the result with those structural change dummies. $ ^{12} $ The signs and statistical significances of the coefficients on the five basic explanatory variables are not largely affected even after the inclusion of dummy variables, except for the coefficient on the capital-asset ratio, which becomes statistically indifferent from zero.

On the other hand, coefficients on newly added variables all indicate that the depositors' response to the bank risk characteristics changed to enhance their disciplinary role at the selected timings of structural changes. For instance, the coefficients on the capital-asset ratio significantly increased both at FY1995 and at FY1999, indicating that depositors got concerned about the ratio when they choose banks to deposit their precious nest egg. Although FY1995 is one year earlier than the timing of the capital ratio parameter shift observed in the cross-section regressions in Table 5, relatively large deposit-taking institutions, such as Hyogo Bank and Kizu Credit Cooperative, $ ^{13} $
failed in FY1995, the year that the use of the jargon “pay-off”—which started to appear after FY1994—surged in articles of major Japanese newspapers (see Table 7). The failures possibly worked as a “wake-up call” for depositors, as proposed by Martinez, Peria, and Schmukler (2001). The second point of parameter shift, i.e., March 2000 (FY 1999), is the month one year before the scheduled closing day of the blanket guarantee (the closing day was postponed by one year to March 2002 in the end, however). Appearance of the phrases “pay-off” and “capital ratio” in Japanese major newspapers reached a peak in that year (FY1999). Reflecting these concerns about the soundness of banks, Japanese small-account depositors intensified their preferences for institutions with higher net worth.

Coefficients on other variables also shifted significantly toward the direction of more disciplinary depositors. The positive coefficient on the share of real-estate-related loans decreased in FY1999, reflecting the recent rise in depositor precautions against banks with heavy real-estate-related loans. The coefficient on the profitability sharply increased in FY1999, indicating depositors' preference for more-profitable banks. The coefficient on the bank size proxy, i.e., the logarithm of institution's total assets, slightly but significantly increased in both FY1995 and FY1999.

The cross-section and panel regressions shown above are all in reduced forms with lagged explanatory variables. Before closing this subsection, we would like to present the results of a structural regression that includes nominal interest rate as an additional explanatory variable $ ^{14} $ . Column (3) of Table 6 reports the result. Inclusion of the new variable does not noticeably change the signs and significance of the coefficients examined above. The coefficient on the newly included interest rate is positive and statistically significant, showing that small-account depositors in our sample normally conform to the rule of market economy.

In summary, findings of our regression analyses on Japanese small financial institutions indicate that small-account depositors are disciplined by nature and that their discipline is polished in confrontation with the environments in which depositors assume self-responsibility.

### 4.2 Deposit Insurance and Market Discipline

This section examines the effects of deposit insurance on market discipline. Here, we present evidence that proves close ties between depositor behavior and the design of the deposit insurance system.
#### 4.2.1 The Effect of the Partial Lift of the Freeze on the Payoff System

In spring 2002, a number of measures to protect the full amount of deposits in Japan were finally terminated. Although the full protection for demand deposits (current deposits, ordinary deposits, and specified deposits precisely) was extended at least until March 2003, that for time deposits was abolished and their insured amount was set, up to a maximum principal of ¥10 million per depositor per financial institution, plus interest (limited coverage). It is a well-known fact in Japan that this institutional change caused a considerable shift of money from time deposits to demand deposits (see Figure 1). What we are interested in is the relation of this defensive reaction of depositors and the characteristics of banks in which depositors put their money. Our guess is that the incentive to shift their money from time deposits to demand deposits is weak for healthy bank depositors (or strong for unhealthy bank depositors) if depositors distinguish a good bank from a bad one.

To examine that inference, we ran a few regressions of the following unique specification:

$$ \Delta\frac{D e m a n d\;D e p o s i t s_{i,t}}{T o t a l\;D e p o s i t s_{i,t}}=f_{i}+d_{t}+\beta\;B a n k\;f u n d a m e n t a l s_{i,t-1}+e_{i,t}\;. $$

Explained variable is the annual change of the ratio of demand deposits to total deposits for each institution. The advantage of this formulation is that it allows us to extract this policy effect exclusively of other factors. As our independent variables, we use the same five variables as the regression (2), i.e., the capital-asset ratio, the share of real-estate-related loans, the liquidity of assets, bank profitability, and bank size proxy. The first column of Table 8 reports the result of a panel regression (within estimates) on the data from FY1992 to FY2000, one year before the institutional change that we want to examine. The liquidity of assets and the bank size term had a positive correlation on the demand deposit ratio change over the period. The coefficients on other variables are not different from zero.

The regression result (column (2)) that includes FY 2001 data shows much stronger correlation between the change in demand deposit ratio and bank characteristic variables. R-squared rises substantially. The capital-asset ratio has a negative effect, indicating that depositors of banks with low capital ratios shifted their money to fully protected demand deposits more earnestly. $ ^{15} $ The coefficient on the real-estate-related loan share is significantly positive, suggesting depositor concern
for the soundness of banks with excessive real-estate loans. A negative coefficient on the profitability term is also in line with our inference that the change in demand deposit ratio should have some correlation with the bank characteristics.

Since the inclusion of FY2001 observations changes the statistical significance of estimated coefficients drastically, we tried dummy variables to account for a possible parameter shift in our regression (see column (3)). The estimated coefficients on the FY2001 dummies are very large and statistically significant for all five variables. The findings from our demand deposit ratio regressions eloquently demonstrate that the rush to demand deposits observed in spring 2002 was led by the behavior of unhealthy bank depositors.

#### 4.2.2 The Effect of the Postponement of the Payoff Reintroduction

As our second illustration of the relation between depositor behavior and the deposit insurance system, we take an example of change in the schedule of payoff reintroduction. Although the payoff scheme was reintroduced for time deposits in April 2002, unlimited protection for demand deposits, i.e., current deposits, ordinary deposits, and specified deposits, was extended initially until March 2003, and finally until March 2005. Furthermore, in December 2002 the government announced the introduction of a permanent measure to fully protect newly defined “payment and settlement deposits,” $ ^{16} $ which will be enforced from the beginning of April 2005.

To examine the effect of the postponement of payoff reintroduction and the introduction of newly defined deposits with full protection, both announced in FY2002, we extend our panel data for an extra year and regress Equation (2), including dummy variables to allow for parameter shifts in FY2002. The negative interaction term of capital-asset ratio and FY2002 dummy (as reported in the first column of Table 9) suggests that the sensitivity of depositors to bank risk becomes lower in FY2002. Our result and previous Japanese studies, i.e., Hosono (2003) and Tsuru (2003), agree on the point that the depositors' discipline depends on the design of the deposit insurance scheme. And the result here demonstrates further that the finding holds even for small-account depositors who go into the ¥10 million maximum insurance payments.

### 5. Conclusion

This paper empirically investigates the issues of market discipline by examining Japanese small deposit-taking institutions in the 1990s. We are here concerned with two questions that are
relevant to the design of a new regulatory framework for Japanese banking, namely: 1) whether market discipline has effectively worked since the early 1990s in Japan, and 2) whether changes in the regulatory frameworks, including the deposit insurance scheme, affect the extent of market discipline. Though the previous studies found that Japanese depositors discriminate across banks on the basis of the risk of bank failure, the evidence may not be applied to depositors of smaller financial institutions, such as shinkin banks and credit cooperatives, since they are not well informed of bank risks and the majority of them are snugly wrapped in the (limited) deposit insurance.

The results obtained in this paper show that deposit growth is negatively correlated with the risk of financial institutions. The relative importance of market discipline rises both in FY1995 and FY1999. The first shift is associated with the failures of relatively large financial institutions. The second shift in FY1999 suggests that depositors acted on that timing in anticipation of the reintroduction of a “pay-off” scheme, which was planned to be enforced one year later.

Our results also show that the extent of market discipline is clearly affected by changes in regulatory frameworks, especially those of deposit insurance. The fact that the presence of market discipline is confirmed even for the small-account depositors may suggest their financial literacy and the importance of restitution costs. It is, therefore, important for policy-makers to understand the implications of these empirical findings and to design financial safety nets so as to make the best use of the market discipline by all kinds of depositors.
## References

Basel Committee on Banking Supervision (2003), Consultative paper, “The New Basel Capital Accord,” April, 2003, Bank for International Settlements.

Boot, Arnoud W. A., and Thakor, Anjan V. (1993), “Self-interested Bank Regulation,” American Economic Review, Vol. 83(2), 1993, pp. 206-212.

Demirgüç-Kunt, Asli and Edward J. Kane (2002), “Deposit Insurance Around the Globe: Where Does It Work?” Journal of Economic Perspectives, Vol. 16, No.2, 2002, pp. 175-95.

Demirgüç-Kunt, Asli and Harry Huizinga (2004), “Market Discipline and Deposit Insurance,” Journal of Monetary Economics, Vol. 51, 2004, pp. 375-399.

Flannery, Mark J. (1996), “Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence,” Journal of Money, Credit and Banking, Vol. 30, No.3, 1996, pp.273-304.

Hirschman, Albert O. (1970), Exit, Voice and Royalty: Response to Decline in Firms, Organizations, and States, Harvard University Press.

Hosono, Kaoru (2003), “Depositors’ Discipline During the Banking Crisis in Japan,” 2003, mimeo.

Hosono, Kaoru, Hiroko Iwaki, and Kotaro Tsuru (2004), “Bank Regulation and Market Discipline around the World”, 2004, mimeo.

Martinez Peria, Maria Soledad, and Sergio L. Schmukler (2001), “Do Depositors Punish Banks for Bad Behavior? Market Discipline, Deposit Insurance, and Banking Crises,” Journal of Finance, Vol. 56, No. 3, 2001, pp. 1029-51.

Tsuru, Kotaro (2003), “Depositors’ Selection of Banks and the Deposit Insurance System in Japan: Empirical Evidence and its Policy Implications,” RIETI Discussion Paper Series 03-E-24, 2003.