Too Many To Fail:

The Effect of Regulatory Forbearance on Market Discipline

Wook Sohn and Hyosoon Choi

ABSTRACT

This paper investigates whether regulatory forbearance for savings banks in Korea affects
the market discipline of depositors using data from 2000 to 2010, which are characterized
by a series of exits of savings banks. We find that depositors sensitivity to the savings
banks asset quality decreases when there is regulatory forbearance for failing savings
banks. This forbearance effect is also observed in the behavior of the depositors of the
neighboring savings banks in the same business area. These results suggest that
regulatory forbearance may cause depositors to misjudge bank risks, increasing the
expected costs of bank failure.
Keywords: Depositor discipline, Regulatory forbearance, Prompt corrective action,
Savings bank, Korea
JEL Classification: G21, G28

Wook Sohn: KDI School of Public Policy and Management, 87 Hoegiro, Seoul 130-868, Korea; phone:

+82-2-3299-1062; e-mail: wooksohn@ kdischool.ac.kr.

Hyosoon Choi: Korea Deposit Insurance Corporation, 33 Da-Dong, Seoul, 100-180, Korea; phone: 82-2758-0901; e-mail: hschoi@kdic.or.kr.

Too Many To Fail:

The Effect of Regulatory Forbearance on Market Discipline

ABSTRACT

This paper investigates whether regulatory forbearance for savings banks in Korea affects
the market discipline of depositors using data from 2000 to 2010, which are characterized
by a series of exits of savings banks. We find that depositors sensitivity to the savings
banks asset quality decreases when there is regulatory forbearance for failing savings
banks. This forbearance effect is also observed in the behavior of the depositors of the
neighboring savings banks in the same business area. These results suggest that
regulatory forbearance may cause depositors to misjudge bank risks, increasing the
expected costs of bank failure.

Keywords: Depositor discipline, Regulatory forbearance, Prompt corrective action,

Savings bank, Korea

JEL Classification: G21, G28

1. Introduction

Market discipline constrains the risk-taking behavior of banks and thus has the
potential to contribute to reducing the probability of bank failures and minimizing the
costs 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 from bank failures have provoked serious criticism of
regulatory forbearance, which 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).1 Although market discipline has been considered a supplement to direct
regulation in the control of bank risks, research addressing the direct interaction between
regulatory forbearance and market discipline is sparse.2

Allen and Saunders (1993), Dreyfus et al. (1994) and Nagarajan and Sealey (1995) introduce regulatory

forbearance into their theoretical models of valuation of deposit insurance. However, they do not focus on
the effects of regulatory forbearance on market participants behavior. Hanweck and Spellman (2002) and
Schellhorn and Spellman (2000) examine the effect of forbearance on subordinated debt yields and
shareholders behavior.
2

Pillar 3 of the Basel II Accord of the Basel Committee on Bank Supervision views market discipline as a

complement to minimum capital requirements or supervisory processes.

This study attempts to examine the effect of forbearance on depositors market

discipline. To find evidence for regulatory forbearance diminishing market discipline, we
empirically test whether the sensitivity of deposit growth rate to bank risks is affected by
regulatory forbearance. We examine not only the depositors of the banks subject to
forbearance but also those of neighboring banks.
If depositors believe that a regulator does not intend to close a bank in the
foreseeable future, they will not withdraw their deposit, 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 regulators 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. Moreover, if regulator forbearance is combined with
generous deposit protection from insurers, the impairment of market discipline will be
more pronounced and evident. This situation is more likely to be observable in
developing nations, where mandatory information disclosures are less frequent and bank
regulations are more prone to be influenced by politics than in advanced countries.
Considering the regulatory environment of savings banks, we believe that Koreas
savings bank industry provides a good opportunity to test our hypotheses. The laboratory
of our study is a set of savings banks in Korea from 2000 to 2010, which is a period

characterized by a series of exits of savings banks under the restructuring of the

regulatory authority.
The contribution of this paper stems from the literatures excessive focus on U.S.
data since the early 1990s. Evidence from another country, one that is sufficiently
different from the U.S. 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 II, which will be
applied internationally. To this end, we scrutinize depositor behavior under countryspecific circumstances where there is a high possibility of regulatory forbearance.3
This study contributes to the literature in two more aspects. First, we identify
regulatory forbearance using cases where the regulator explicitly postpones Prompt
Corrective Actions (PCAs) or does not take any action for failing banks. Second, we test
the spillover effect of forbearance by analyzing the behavior of depositors of other banks
in the same operating region as the banks subject to regulatory forbearance.
We find that the sensitivity of deposit growth rates to banks non-sound asset ratios
significantly decreases when regulatory forbearance is apparent. These forbearance
effects are observed not only in the banks subject to forbearance but also in neighboring
banks in the same business region. Based on the findings, we suggest that savings banks
risk information be more accurately disclosed, especially through the regulators
supervisory measures. Otherwise, regulatory forbearance may cause an increase in the

Variations in the extent of market discipline across countries should in part reflect international

differences in the operation of the financial safety net to limit depositor losses in the case of a bank failure.

expected costs of bank failure through depositors loose discipline with regard to bank
risks.
This paper is organized as follows. Section 2 describes the regulatory forbearance
and its relationship to market discipline. Section 3 explains the characteristics of Korean
savings banks and the regulatory environment. In Section 4, we propose our hypotheses
and develop empirical models to test them. Empirical results are provided in Section 5.
Section 6 concludes the paper.

2. Regulatory forbearance and market discipline

Regulatory forbearance can be defined as a discretionary delay in enforcing

appropriate actions to reduce the cost of bank failure. Previous studies have used the term
forbearance in various contexts, such as the delay of a PCA, the delay of receivership
(Schellhorn and Spellman, 2000), and bailouts without enforcement rules (Osterberg and
Thomson, 1992).
Why does regulatory forbearance occur? One explanation is a breakdown in the
incentives that cause the regulator to defend the regulated banks (Kane, 1986, 1990; Boot
and Thakor, 1993). In particular, Boot and Thakor (1993) formalize the notion that a bank
regulator may pursue self-interest rather than social welfare. According to this model, the
regulators desire to acquire a reputation as a capable bank monitor can distort bank
closure policy and increase the liability of deposit insurance. Schellhorn and Spellman
(2000) suggest that regulators may delay receiverships for banks they believe are
insolvent when the banks stockholders have the potential to appeal to the courts to

reverse the receivership and assess monetary damages. Allen and Saunders (1993) argue
that the response of regulators has often been characterized by delay due to budgetary and
political considerations. In this paper, regulatory forbearance is defined as the
postponement of a PCA or no PCA for failing banks.
U.S. bank regulators have been criticized for their slow and inadequate response to
the thrift crisis as well as for the forbearance granted to many failing savings and loan
associations in the late 1980s. 4 However, the empirical evidence on the cost of
forbearance is largely inconclusive. Mailath and Mester (1994) suggest that forbearance
may sometimes be optimal, whereas Acharya and Dreyfus (1989) argue that forbearance
is always suboptimal. The question of whether the enforcement of regulations must be
restricted to explicit, pre-announced and credible rules or whether regulator discretion
should be maintained is yet unanswered (Sijben, 2002). Benston and Carhill (1992) argue
that forbearance may have saved the Federal Savings and Loan Insurance Corporation
(FSLIC) a significant amount of costs ex post in the 1980s. In contrast, DeGennaro and
Thompson (1996) argue that the regulatory forbearance of the early 1980s was costly to
regulators and a bad bet for taxpayers. However, all of these papers focus on ex post costs
and do not shed light on ex ante costs or the benefits of forbearance (Nagarajan and
Sealey, 1995).5
4

Huizinga and Laeven (2010) show that banks have systematically understated the impact of the

impairment of assets on bank capital in their financial reporting, which is evidence of widespread
regulatory forbearance toward distressed banks during the financial crisis. Choi (2002) also reports
regulatory forbearance during the financial crisis in Korea.
5

In the context of Japan, Dekle and Kletzer (2004) use an endogenous growth model with financial

intermediation to show that deposit insurance with regulatory forbearance leads to banking crises.

The term market discipline is commonly associated with two different meanings.
Bliss and Flannery (2000) argue that the concept of market discipline incorporates two
distinct components: market monitoring and market influence. Market monitoring refers
to the hypothesis that investors accurately understand changes in a firm's condition and
promptly incorporate their assessment into the firm's security prices. Since the mid-1980s,
a number of studies have examined whether uninsured depositors respond to bank risks
by withdrawing their deposits and/or requiring higher interest rates. Although not
unanimous, these studies find evidence consistent with the hypothesis that market
discipline is at play (Ioannidou and de Dreu, 2006). Market influence is the process by
which a security price change leads firm managers to counteract adverse changes in firm
conditions.
The interaction between bank regulation and market discipline has also been shown
to differ depending on the situation. Jordan et al. (1999) find that the announcement of a
formal enforcement action results in a large negative abnormal stock return for the bank,
suggesting that the announcement reveals new, adverse information about the banks
financial condition. However, Gilbert and Vaughan (2001) find no evidence of unusual
deposit withdrawals or spread increases around the announcements of regulatory
enforcement actions. They conclude that the public announcement does not spark bank
runs or enhance depositor discipline.6
6

Empirical tests of market discipline have been executed in various contexts. Factors affecting market

discipline are the deposit insurance system (Cook and Spellman, 1991; Demirguc-Kunt and Huizinga,
2003; Ioannidou and de Dreu, 2005), bank failure (Goldberg and Hudgins, 1996; Jordan, 2000; Jagtiani and
Lemieux, 2001), banking crises (Martinez Peria and Schmukler, 2001), and ownership structure
(Mondschean and Opiela, 1999).

3. Savings banks and the regulatory environment in Korea

Savings banks in Korea are depository institutions that are licensed and supervised
by the Financial Supervisory Commission (FSC). They issue demand and savings
deposits insured by the Korea Deposit Insurance Corporation (KDIC). The savings bank
industry of Korea in the early 2000s represents an interesting case for analyzing the
impact of regulatory actions on depositors market discipline. During the period of this
study (2000-2010), Korea was in the late stage of its banking sector restructuring, which
began shortly after the financial crisis of 1997. The restructuring of the commercial
banking sector was coming to an end in 2000, but the restructuring of the savings banks
did not begin until late 1999. The reasons for such a delay in restructuring savings banks
are two-fold. The first is that the deteriorated credit of small- and medium-sized
enterprises and individuals, who were the main customers of savings banks, was
disclosed later than that of large corporations. Second, the regulatory authority did not
place a priority on the restructuring of savings banks due to their relatively small scale
and low systemic risk.
There has been a dramatic change among savings banks in Korea since the
restructuring of the savings bank industry. As of the end of 1999, 186 savings banks were
in operation. Among the 186 savings banks in existence at the end of 1999, 88 savings
banks were restructured by license revocations, mergers and acquisitions (M&As), or
purchase and assumptions (P&As) by 2010. During this period, nine banks were newly

established, and two of them were restructured. As a result, the number of savings banks
was reduced to 105 by the end of 2010 (see Table 1).7
As shown in Table 1, deposit insurance protects 77.4% of the total amount of
deposits and 98.2% of the total number of depositors as of the end of 1999. Depositor
protection for savings banks in Korea can be characterized as follows. First, membership
is compulsory. Savings banks automatically become a member of the deposit insurance
system as soon as they become licensed for business, and the membership status is
maintained until the business license is revoked or until they are liquidated or declared
bankrupt. Second, all types of deposits are insured, including term deposits, time
installment savings, mutual installments, and cover notes. Third, the coverage limit is set
at 50 million won, nearly five times as high as the 2001 per capita GDP of Korea.
Savings banks that survived the restructuring made efforts to meet the capital
requirements strengthened by the forward-looking criteria of the FSC. As a result, the
overall financial condition of savings banks improved: the substandard credit ratio
decreased substantially from 26.2% to 10.8%, and the BIS capital ratio improved by 2.47
percentage points. Meanwhile, as is evidenced by the average number of branches per
savings bank (1.5) as of the end of 1999, the business of a savings bank is conducted
mostly in the operating region of its head office.
7

However, despite the decrease in the number of savings banks, the industrys scale grew approximately

250% in terms of both assets and deposits during that period. This high growth rate is attributed to the fact
that the assets and liabilities of insolvent savings banks were transferred to other acquiring savings banks
and that deposits in the closed savings banks were protected by deposit insurance and absorbed into other
savings banks.

The characteristics of Korean savings banks and the regulatory environment must be
explained because they should contribute to bringing different empirical results from
others. First, the asset sizes of individual savings banks are small relative to other
depository institutions. The possibility of one savings banks failure threatening the
stability of the financial system of the nation is therefore low. This characteristic means
that the too big to fail doctrine is not applied when the regulatory authority makes the
closure decisions for failing banks.
Second, in the early 2000s, there were too many financially weak savings banks for
the regulator to close them all at once. Approximately 30% of the savings banks had a
negative equity book value, and the regulator may have had to consider the potential
adverse economic effects of bank closures. In other words, too many to fail was a
major concern for the regulatory authority.
Third, there is little publicly available and reliable risk information because the
capital level is low and shareholders are not diversified. In May 2002, the FSC reinforced
a disclosure policy that made savings banks disclose their management conditions,
including their BIS capital ratio. However, the large number of savings banks has made it
difficult for the regulator to conduct frequent on-site examinations, decreasing the
reliability of risk information. Due to this shortage of reliable information on the risk
profile of savings banks, depositors are much more likely to depend on regulatory actions
for their decisions. In addition, historically in Korea, bank failures have mostly been
triggered by regulatory action, not by bank runs. This finding could be another reason
why depositors pay more attention to the regulators intention than to the banks financial
condition.

Fourth, savings banks operate within a small, restricted region because of their low
level of capital and small number of branches. This characteristic makes savings banks
competition and performance specific to the restricted operating region. Under this
circumstance, depositors have good reason to believe that their banks probability of
failure is closely correlated with that of neighboring banks.

4. Data and empirical models

4.1. Measuring regulatory forbearance

Identifying the existence of regulatory forbearance is not an easy task because many
factors influence regulatory outcomes. In this study, regulatory forbearance is identified
by using an explicit announcement of forbearance by the regulatory authority and the
accounting data disclosed by savings banks.
The regulatory authority may enforce a PCA on a savings bank that is undercapitalized or that has scored a low grade in the management evaluation. The criteria of
PCA enforcements are essentially based on both the risk-weighted capital ratio and the
management status evaluated by the FSC. There are three types of PCAs: recommend,
demand, and order of management improvement. For instance, a savings bank with a
BIS ratio under 1%, 3% and 5% is given a PCA of order, demand and recommend,
respectively. When the authority enforces a PCA, it reveals its decision to the public.
Although the main purpose of PCAs is to preclude regulatory forbearance, the law allows
regulators to take discretionary action. The regulator sometimes chooses not to enforce a
PCA for a particular savings bank for some period when it believes that there are reasons

10

to hold off. Such information is also released to the public. We name this type of
forbearance PCA postpone.
The three types of PCAs (recommend, demand and order) are meant to indicate the
strength of the each PCA. For example, PCA measures that are imposed on the savings
banks are stronger in the case of PCA order than in the case of PCA recommend.
However, the discretionary decision on PCA postpone is based not on the strength of
the PCA types but on how plausible and implementable the management improvement
plan submitted by a savings bank to the regulatory authority is. 8 Therefore, it is not
always the case that PCA postpone is more likely to occur when a savings bank is
categorized as requiring PCA recommend than PCA order. In fact, Table 2 shows
that there were 15 cases of PCA postpone, among which 12, 2 and 1 cases were
categorized as PCA order, demand and recommend, respectively, according to the
criteria of financial soundness if PCAs have been executed for these banks. This finding
suggests that regulatory forbearance was more likely to be given to a savings bank that
merited a stronger regulatory measure.
The second type of forbearance is detected using savings banks accounting
information. If a given savings bank approaches failure in default by book value, that is,
its liabilities exceed its assets, and if no regulatory action is taken against that savings
bank, we assume that regulatory forbearance occurs. We name this type of forbearance
no action.
8

According to the Regulation of Supervision of Mutual Savings Bank Business (Article #50) enacted by

the FSC, the supervisor may postpone a PCA enforcement for a specified period of time under PCA criteria
when it is recognized that a savings bank is likely to satisfy the standards within a short period of time
through an increase in capital or the sale of its assets.

11

Table 2 summarizes the supervisory measures taken against savings banks and the
ultimate status of the savings banks from January 2000 to 2010. As of the end of 1999,
PCAs were taken for the 49 savings banks in the form of recommend, demand, or
order.9
After tracing the restructuring of savings banks, we find that some savings banks
were revoked or consolidated without previously being subject to PCAs or developing a
negative equity book value; these banks are classified as sudden closure (31 savings
banks). Depositors in this type of savings bank would not have been aware of their banks
upcoming restructuring because the regulatory authority would have been unable to take
any measure, due to the banks the sound financial structure. Considering that most
M&As and P&As in the savings bank industry were initiated by the regulator, we classify
sudden closure in the category of the enforcement group. The enforcement group
thus consists of 49 PCA-enforced savings banks and 31 savings banks of sudden closure.
In the category of regulatory forbearance, there are 16 PCA-postponed savings
banks and 32 savings banks subject to a no action of any supervisory measure (we refer
to these 48 savings banks hereafter as the forbearance group). The no action is
assumed to have occurred three months after the banks equity capital became negative,
considering that this a sufficient amount of time for the banks to report and for the
regulators to take action. Finally, 67 savings banks are classified as in a healthy state
because they ran their business without any record of enforcement or forbearance

Seven savings banks are excluded due to incomplete data on restructuring. Though not specified in Table

2, there are some savings banks that have been subject to PCAs more than once. In this case, the type of
PCA is recorded according to the first PCA type.

12

and their equity values remained positive during the entire period of this study.
After tracing the restructuring of savings banks until the end of 2010, we find that 31
savings banks, or 63.3% of the 49 PCA-enforced savings banks, were closed. Of the 48
savings banks in the forbearance group, 28 were restructured, accounting for 58.3% of
the banks in this group, which is a percentage surprisingly similar to that of the PCAenforced savings banks.

4.2. Empirical models

It has been well recognized that depositors reactions to banks financial weakness
could occur through a decrease in deposits. If bank failures are mainly triggered not by a
stream of deposit withdrawals but by regulatory action, bank regulators intentions would
become one of the determinants of bank failures. Under the circumstance in which the
regulator postpones a PCA for a failing bank or does not take any regulatory action,
depositors may believe that the bank has the ability to recover. Although depositors
expect that the failing bank will eventually fail, they may believe that there remains
sufficient time to withdraw funds before the regulator closes the failing bank. We thus
present the following hypothesis:

(H1) Regulatory forbearance for failing banks diminishes the effects of depositor risk
sensitivity on the banks deposit growth rates.

The depositors of neighboring banks find no reason to hurry and withdraw their

13

deposits, despite the weak financial condition of their banks, because they may believe
that the regulator will apply the same laxity to their banks. In other words, regulatory
forbearance for some banks may lead neighboring banks depositors to expect similar
treatment in the future. We thus present the following hypothesis:

(H2) Regulatory forbearance for failing banks diminishes the effects of depositor
risk sensitivity on neighboring banks deposit growth rates.

Our hypotheses are partly related to the theoretical development of regulatory

forbearance and market discipline. Alen and Saunders (1993) and Dreyfus et al. (1994)
introduce regulatory forbearance into their theoretical models valuating deposit insurance.
In particular, Dreyfus et al. (1994) construct a theoretical model to show that the costminimizing insured deposit cap is at a higher level in the presence of moral hazard (more
regulatory forbearance) or an inelastic supply of deposits (less discipline among
depositors).
In contrast to the existing literature, Morrison and White (2011) justify regulatory
forbearance on failing banks. A banks failure through the regulators decision
undermines confidence in the regulators competence, leading depositors to withdraw
funds from other banks screened by the same regulator. The optimal regulatory response
to avoid this contagion effect is to exhibit forbearance privately to a failing bank.
Nagarajan and Sealey (1995) also show that a state-contingent forbearance policy can be
an effective tool for alleviating risk-shifting behavior among banks.
Before testing the effect of forbearance on depositors market discipline, we must

14

examine whether depositors market discipline exists in Korean savings banks. Because a
depositors response to savings bank risk is reflected in their deposit behavior, we run
regressions of deposit growth rate (and uninsured deposit ratio) on savings bank risk
variables as follows.

Deposit Growthit (or Uninsured Depositit) = 0 + 1 NSAit-1 + 2 Capitalit-1 + 3 ROAit

+ 4 Sizeit-1 + 5 Liquidityit + 6 Deposit Interestit + 7 Interest Ratet + 8
GDPt + j 9j YRj + 1it

(1)

where Deposit Growth is the change in the log of the total deposits of savings bank i
during a quarter t and Uninsured Deposit is the ratio of uninsured deposits to total
deposits. NSA is the non-sound asset ratio. Capital is equity/total assets. ROA is net
income/total assets. Size is the log of total assets. Liquidity is total deposits/total loans.
Deposit Interest is interest payment/total deposits. Interest Rate is the average interest
rate on commercial banks time deposit. GDP is the GDP growth rate during the quarter.
YR are year dummies indicating 2001 through 2010.10 The variables NSA, Capital, and
Size are measured by their values at the end of the previous quarter.
The dependent variables are the total deposit growth rate or the uninsured deposit
ratio. We believe that deposit insurance is the main driver that weakens market discipline
and thus that we should consider that depositors who are not covered would have much
more incentive to care about regulatory forbearance. We therefore use the uninsured part

10

The non-sound asset ratio (NSA) is calculated as (substandard loan + non-operating real estate) / (total

loan + non-operating real estate).

15

of deposits as a dependent variable to pin down the effect of regulatory forbearance on

the discipline.11
We also use the total deposit growth rate as a dependent variable because even
though their deposit amount is below the coverage limit, depositors have incentives to
have market discipline. Protected depositors also face risks in the event of their bank
failure, such as financial losses from possibly low interest payments and economic losses
from inconvenience in transactions and delay in payment. First, depositors are unable to
transact with their account in the event of bank failure. Second, they may lose some
interest because KDIC does not protect interest that exceeds some level KDIC designates
based on commercial banks interest level, which is substantially lower than that of
savings banks. Third, depositors must wait for several months before receiving their
deposit claims; the average time to pay claims from the suspension is 5.1 months for
savings banks failed during 2003-2010, whereas in the U.S., deposit claims are normally
paid out in the next working day.
Regarding the explanatory variables, we choose to use the variables that the
regulator uses in monitoring, as well as those that empirical studies have shown to be
important explanatory variables in the deposit models.
After examining the existence of depositors market discipline, we test whether
market discipline is weakened by regulatory forbearance. We expect that depositors

11

Goldberg and Hudgins (1996) and Park and Peristiani (1998) also use the uninsured deposit ratio or its

growth rate, whereas Demirgc-Kunt and Huizinga (2003) and Ioannidou and de Dreu (2006) use the total
deposit growth rate as a dependent variable.

16

perception of forbearance makes them less sensitive to proxy variables indicating the
possibility of failure of a savings bank.
Studies of the effect of a regulatory action typically employ three different means of
analysis: (1) regressions using a dummy variable indicating a regulatory action, (2)
regressions for subsamples of pre- and post-action and (3) a simple comparison of
variables of interest for sample and control groups. First, Athavale (2000) uses an event
dummy variable representing too-big-too-fail policy in an ordinary least square (OLS)
regression to analyze the effect of the policy on a depositors behavior. He finds that
markets perceive uninsured bank deposits to be safer because of the regulatory
forbearance the commitment to the TBTF policy. Aggarwal and Jacques (1998) also
use dummy variables to signify the degree of regulatory pressure in their OLS regressions.
Second, Barajas et al. (1999) and Hall et al. (2004) run regressions for the subsample of
before and after the banking liberalization and the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA), respectively. Third, Gilbert and Vaughan (2001)
simply compare deposit growth rates before and after the announcements at the sample
banks and a control group. Goldberg and Hudgins (2002) also measure depositors
reactions to the announcements of enforcement actions.
We use the first approach using a dummy variable indicating periods of regulatory
forbearance for each savings bank. We use a dummy variable D1 or D2 to introduce
regulatory forbearance into the regression model as follows.

Deposit Growthit (or Uninsured Depositit) = 0 + 1 D1 (or D2)+ 2 NSAit + 3 D1

(or D2)*NSAit + 4 Capitalit + 5 D1 (or D2)*Capitalit + 6 ROAit + 7 Sizeit

17

+ 8 Liquidityit + 9 Deposit Interestit + 10Interest Ratet + 11GDPt + j

12jYRj + 2it

(2)

The dummy variable indicating regulatory forbearance is defined differently when

we test the two hypotheses. In testing (H1), D1 in regression model (2) is one if the
regulatory actions is PCA postpone or no action and zero otherwise. We consider a
three-quarter time window centered on the quarter when regulatory forbearance occurs to
allow information leakage and a slow adjustment of depositors. In other words, D1 is one
for t = -1, t = 0, and t = 1, where t = 0 represents the quarter when the regulatory
forbearance occurs.
We define a business region as a whole whether it is a forborne or enforced region.
We use the number of cases of two types of regulatory responses when banks are failing.
Therefore, D2 is one if the number of cases of forborne (PCA postpone and no
action) banks exceeds that of enforced (PCA enforcement and sudden closure)
banks within the operating region of each savings bank and zero otherwise. For instance,
there were one enforcement and three forbearance cases in the region of Pusan in the
fourth quarter of 2000 (PCA postpone). In this case, the number of enforcement cases
(3) is greater than the number of forbearance cases (1). We thus state that there was
forbearance in the Pusan region for that quarter and set the dummy variable to one for all
healthy banks located in Pusan for the fourth quarter of 2000.
In testing whether regulatory forbearance for a particular savings bank impacts the
neighboring savings banks depositors (H2), we run the regression only for the subsample
of healthy savings banks. Savings banks that ran their business with no record of

18

forbearance or restructuring during this research period are classified as being in a

healthy state to measure the influence of risks of unhealthy savings banks in the same
business area.12
We conduct pooled regressions of all the observations. We are concerned about the
sudden increase in deposits simply from acquiring deposits from failed savings banks.
Therefore, we check whether there was a sudden increase in deposits for an acquiring
savings bank from M&As or P&As during the sample period. We identify nine cases of
sudden increase in deposits from M&A and eight cases from P&A. We exclude these 17
savings banks in our analyses to remove the effect of consolidation on the deposit growth
(see page 17).

5. Empirical evidence

5.1. Data and summary statistics

The non-sound asset ratio and capital ratio are drawn from the balance sheet and
income statement data of individual savings banks. The other sources of data consist of
Quarterly Business Reports and Monthly Deposit Reports filed with the KDIC. These
reports publish ROA, size of assets, loans and deposits, uninsured part of deposits, and
interest payment. Data are collected during the period from January 2000 to December

12

The fifteen operating regions are based on the administrative regions of the nation as follows: Seoul,

Pusan, Incheon, Taegu, Daecheon, Kwangju, Kyeongki, Kangwon, Chungbuk, Chungnam, Cheonbuk,
Cheonnam, Kyeongbuk, Kyeongnam, and Jeju.

19

2010, which is characterized by a series of exits of savings banks resulting from the
restructuring plan of the Korean regulatory authority.
Table 3 presents summary statistics of major variables of interest during the period
from 2000 to 2010. The deposit growth rates (Deposit Growth) of both enforcement
(panel A) and forbearance (panel B) groups are negative, and the difference of the two
groups in not statistically significant. The uninsured deposit ratio (Uninsured Deposit) of
enforcement is 22.5%, whereas that of forbearance is 17.9%, and the difference is
statistically significant. Judging by capital ratio, the enforcement group is found to
have a higher capital ratio than the forbearance group around the announcements of
supervisory decisions. This statistically significant (t=5.15) result suggests that market
participants, who have limited access to the risk information of individual savings banks,
are at risk of misjudgment in evaluating their banks safety when using supervisory
measures rather than financial ratios.
The mean value of deposit growth rates of healthy savings banks (panel C) is 3.3%,
whereas those of savings banks subject to forbearance and enforcement (panel A plus
B) are -0.6% and -0.7%, respectively. The t-statistics on the mean differences between
healthy and unhealthy (enforcement and forbearance together) are 6.28,
suggesting that the difference is statistically significant. The mean difference in the
uninsured deposit ratio of healthy and unhealthy banks is also statistically significant
(t=5.44). We also find that the asset quality, capital adequacy, and profitability of
healthy savings banks are superior to those of unhealthy savings banks. These results
are consistent with the conjecture that market discipline is properly functioning. With
regard to deposit interest rates (Interest), this difference is not statistically significant.

20

In Table 4, the deposit growth rates and the soundness indicators of the
enforcement and forbearance groups are summarized during the previous quarter (t =
-1) and the quarter (t = 0) when regulatory actions or forbearance occurred and the
following quarter (t = 1). The difference in the capital ratio of the two groups is
statistically significant at the end of a quarter ahead of the supervisory actions. It is
surprising that the supervisory authority tends to forbear more for a savings bank with a
lower (in fact negative) capital ratio. It is noteworthy that during the three quarters, the
total deposit growth rate is negative and the uninsured deposit ratio continues to rise in
the enforcement group. This finding suggests that depositors of enforced savings banks
withdraw large shares of the insured portion of their deposits. However, the uninsured
portion of deposits does not change substantially in the case of forborne savings banks.

5.2. Regression results and discussions

Table 5 presents the results of regressions for equation (1), which test whether
market discipline is present in savings banks in Korea. Market discipline can be
determined by the sensitivity of deposit growth rates to the risk variables of savings
banks. In this study, the non-sound asset ratio (NSA) is selected as the major risk variable.
This result shows that the estimated coefficient of NSA (-0.072) for the OLS regression of
Deposit Growth is statistically significant. A low ratio of NSA indicates that the financial
soundness is good, increasing depositors trust level in savings banks. This result remains
the same in the regression of uninsured deposit ratio (Uninsured Deposit). The
statistically significant, positive coefficients of capital ratio (0.036) and ROA (0.043) in
the regression also indicate that a savings bank with more sound financial variables has a

21

higher deposit growth rate.

In addressing the possible endogeneity problem between the deposit growth rate and
the deposit interest payment, we conduct a 2SLS model that measures Deposit Interest in
the predicted term. In other words, in the first stage, Deposit Interest is regressed against
a lagged Deposit Growth and contemporaneous Interest Rate, and the predicted Deposit
Interest is used in the second stage of regression. The results remain qualitatively the
same and statistically significant.13
In particular, the coefficient is larger for the regression of uninsured deposits than
for total deposits. This result is related to that of Park and Peristiani (1998), who report
the presence of market discipline in fully insured deposits, although statistical
significance is substantially lower than in uninsured deposits.14 Overall, we find empirical
evidence supporting the existence of depositors market discipline in the savings bank
industry in Korea.
Most prior work contains only one data point.15 In the U.S., the cost of collecting
and analyzing information on bank conditions has been low, but the benefit from doing so,
13

Maechler and McDill (2006) model an endogenous process of the price and quantity response of

uninsured deposits in the face of deteriorating fundamentals. They find that good banks can raise uninsured
deposits by raising their price, whereas weak banks cannot, suggesting that depositor discipline not only
increases the cost of choosing a higher level of risk but also may constrain bank managers behavior.
14

Goldberg and Hudgins (2002) find that failed institutions exhibit declining proportions of uninsured

deposit ratio prior to failure, suggesting that uninsured deposits will be governed by market discipline.
15

This data point is characterized by a country in which mergers, failures, and Basel I produced an industry

with historically robust capital protection, in which strong macroeconomic performance generated high
rates of profitability and low rates of failure and in which FIRREA and Sarbanes-Oxley strengthened an
already sound disclosure regime.

22

given the strong banking and macroeconomic conditions during the period, may have
been even lower, perhaps accounting for weaker-than-expected market discipline.
Table 6 shows the results for equation (2) of how regulatory forbearance affects the
sensitivity of deposit growth rates to savings bank risks. The major risk variable NSA is
interacted with D, a dummy variable for the savings banks subject to regulatory
forbearance. For our hypothesis that forbearance weakens the market discipline to be
supported, the sign of the estimated coefficient of NSA should be negative, whereas that
of NSA interacted with D should be positive.
As shown in Table 6, in the regression of deposit growth rate, the weakened market
discipline is not evident. However, in the regression of the uninsured deposit ratio, the
coefficients of NSA and D*NSA are -0.079 and 0.161, respectively, and are statistically
significant. This result implies that the sensitivity of uninsured deposits to the non-sound
asset ratio is significantly low for the savings banks subject to forbearance, which is a
result consistent with regulatory forbearance as a weakening force on market discipline.
This result is also consistent with our expectation that the deteriorating effect of
forbearance on market discipline should be more evident in the uninsured portion of
deposits than in total deposits.
With regard to the effect of regulatory forbearance on market discipline, which is
closely related to this study, previous studies do not show consistent conclusions.
Nagarajan and Sealey (1995) argue that the rational forbearance policy can induce banks
to improve the ex ante quality of assets, whereas some recent empirical studies (Hosono
et al., 2004; Covitz et al., 2004) show that stricter regulation may diminish market
discipline. These studies examine the effect of different forbearance levels resulting from

23

the different regulatory regimes across the country (Hosono et al., 2004) or over time
(Covitz et al., 2004). This paper differs from these two studies in that it identifies
forbearance in the regulatory action enforced for a specific bank and not in the overall
regulatory regime of a nation.
This paper is also related to Brown and Dinc (2011) documenting the too-many-tofail 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. They study bank failures in 21emerging market countries in the
1990s to show that a government is less likely to take over or close a failing bank if the
banking system is weak, which implies the existence of too-many-to-fail policy.
Table 7 shows the existence of a forbearance effect on the healthy banks neighboring
forborne or enforced banks. If more savings banks are subject to forbearance measures
than to enforcement, we consider the business area to be a forborne area. The purpose
is to verify the impact of forbearance on the market discipline of depositors in the vicinity.
The coefficient of NSA is -0.156, and that of D2*NSA is 0.101 for the regression of the
uninsured deposit ratio, implying that regulatory forbearance hurts not only the market
discipline of depositors of savings banks subject to forbearance but also that of the
depositors of the neighboring healthy savings banks. This finding supports our hypothesis
(H2). To the best of our knowledge, this is the first paper to show explicitly the contagion
effect of regulatory forbearance on other banks not subject to regulatory actions.

6. Conclusion

24

Using data on savings banks in Korea from 2000 to 2010, this paper examines
whether regulatory forbearance practices affect the market discipline of bank depositors.
Regulatory forbearance is assumed to exist when the bank regulator postpones a PCA or
does not take any explicit action on savings banks whose book value of equity is negative.
We measure the strength of depositors market discipline by the sensitivity of the deposit
growth rate and uninsured deposit ratio to savings banks non-sound asset ratio. The
results show that depositors sensitivity to the savings banks non-sound asset ratio
decreases when there is a regulatory forbearance for failing savings banks. This
forbearance effect is also observed in the behavior of the depositors of healthy savings
banks in the same business area as the forborne banks.
This study suggests a desirable relationship between market participants and bank
regulators from the perspective of enhancing market discipline. Based on the findings, we
suggest that savings banks risk information be more accurately disclosed, especially
through the regulators supervisory measures. Regulatory actions may mislead bank
depositors perception of bank risks and thus should be modified to act as trustworthy
state signals of savings banks risks. This finding leads us to conclude that regulators
should take extra caution when they forebear appropriate actions for failing savings banks,
as such forbearance may cause an increase in the expected costs of bank failure through
depositors insensitivity to bank risks.

25

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29

Table 1. Savings banks in Korea

Number of savings banks

Number of branches
Number of employees
Total asset (bil. Korean won)
Total deposit (bil. Korean won)
Insurance-covered deposit/
Eligible deposit (%)a
#Covered depositors / #Total depositors (%)
Savings banks deposit /
Commercial banks deposit (%)
Substandard credit ratio (%)
BIS capital ratio (%)
Return on asset (%)
#Number of Savings banks with negative equity/
#Number of total savings banks (%)

end-1999
(A)
186
277
4,574
25,704
21,327

end-2010
(B)
105
373
8,863
86,821
76.792

(B/A)-1(%)
B-A(%p)
-43.5
34.7
93.8
237.8
260.1

77.4

91.0

13.6

98.2

96.8

-1.4

4.1

7.8

3.7

26.2
6.57
-1.71

10.8
9.04
-22.89

-15.4
2.47
-21.18

29.5

8.6

-20.9

Note:
a Deposits from the government and other insured financial institutions are not eligible for deposit
insurance.

30

Table 2. Regulatory actions and the status of savings banks

Regulatory Actions

No. of
Savings banks
end-1999

Enforcement
(PCA Recommend)
(PCA Demand)
(PCA Order)
(Sudden Closure)a
Forbearance
(PCA Postpone)b
(No Action)c
Sub-total
Healthy Stated
Total

78
19
9
21
29
46
16
30
124
62
186

Closed
(during 2000-2010)

Established
since 2000
2
2
2
2
4
5
9

Revoked

P&A

M&A

25
1
2
11
11
21
7
14
46

22
8
2
7
5
6
1
5
28

15
15
1
1
16

46

28

16

Survived
(till
end-2010)
18
10
5
3
20
8
12
38
67
105

Notes:
a Sudden Closure refers to a case where a savings bank was restructured without being subject to any
regulatory action or financial default prior to the restructuring.
b PCA Postpone refers to a case where the regulator announced the postponement of PCA.
c No Action refers to a case where there was no regulatory action such as PCAs or restructuring but a
savings bank has financially defaulted.
d Healthy State refers to a surviving bank as of the end of 2010 that was not subject to any regulatory
action or financial default during the period 2000-2010.

31

Table 3. Summary statistics

t-testc

Mean

Std.dev.

Min

Max

Median

0.030
0.246
0.186
0.082
-0.006
0.051
12.249
1.202

0.111
0.149
0.147
0.087
0.170
0.736
1.079
0.339

-1.46
0.01
0.00
-0.67
-2.75
-52.06
9.48
0.04

2.44
0.92
0.96
0.91
2.22
1.38
15.56
5.48

0.023
0.218
0.140
0.072
0.009
0.056
12.117
1.133

-0.007
0.225
0.321
0.045
-0.077
0.064
11.813
1.272

0.080
0.178
0.169
0.086
0.347
0.043
1.066
0.355

-0.29
0.16
0.03
-0.45
-1.62
-0.06
9.48
0.64

0.42
0.74
0.76
0.37
0.77
0.23
14.49
3.14

-0.008
0.173
0.286
0.040
0.007
0.059
11.727
1.180

-0.006
0.179
0.336
-0.009
-0.070
0.065
12.356
1.263

0.129
1.144
0.177
0.107
0.280
0.043
0.962
0.422

-0.72
0.01
0.03
-0.65
-1.99
-0.08
9.93
0.26

0.67
0.79
0.90
0.25
0.72
0.28
14.38
4.08

-0.004
0.159
0.311
0.008
-0.024
0.054
12.375
1.209

0.033
0.249
0.175
0.087
-0.002
0.050
12.258
1.198

0.110
0.148
0.139
0.084
0.154
0.762
1.081
0.335

-1.46
0.01
0.00
-0.67
-2.75
-52.06
9.73
0.04

2.44
0.92
0.96
0.91
2.22
1.38
15.56
5.48

0.025 6.28***
0.221 5.44***
0.132 -19.23***
0.074 15.18***
0.010 7.51***
0.056 -1.24
12.125
2.20**
1.129 -3.59***

Total (n=195)
Deposit Growth
Uninsured Deposit
NSA
Capital
ROA
Deposit Interest
Size
Liquidity
A. Enforcementb (n=80)
Deposit Growth
Uninsured Deposit
NSA
Capital
ROA
Deposit Interest
Size
Liquidity
B. Forbearanceb (n=48)
Deposit Growth
Uninsured Deposit
NSA
Capital
ROA
Deposit Interest
Size
Liquidity
C. Healthy state (n=67)
Deposit Growth
Uninsured Deposit
NSA
Capital
ROA
Deposit Interest
Size
Liquidity

-1.07
2.33**
-0.81
5.15***
-0.20
-0.11
-4.78***
0.22

Notes:
a The number of savings banks (n) include the savings banks established since 2000.
b Enforcement (panel A) consists of PCA recommend, order, demand, and sudden closure, and
Forbearance (panel B) consists of PCA postpone and no action.
c The test statistic on the mean difference between Enforcement and Forbearance is reported in the
last column of Panel A. The test statistic on the mean difference between Healthy state and
unhealthy (a combination of Enforcement and Forbearance) banks is reported in the last column
of Panel C.
e ***, **, and * denote the significance levels of 1%, 5%, and 10%, respectively.

32

Table 4. Comparison between the enforcement and forbearance groups around of supervisory
decisions

t = -1
Enforcement
Forbearance
t-testc
t=0
Enforcement
Forbearance
t-testc
t=1
Enforcement
Forbearance
t-testc

Deposit
Growth

Uninsured
Deposit

NSA-1

Capital-1

.0032
-.0008
.734

.2054
.1884
.523

.2891
.3250
-1.228

.0598
-.0040
3.750***

-.0132
-.0113
-.097

.2261
.1739
1.599

.3326
.3598
-.881

.0406
-.0463
4.427***

-.0123
.0053
-.643

.2565
.1745
1.964*

.3472
.3193
.658

.0312
.0334
-.133

Notes:
a The test statistic on the mean differences between Enforcement and Forbearance
b ***, **, and * denote the significance levels of 1%, 5%, and 10%, respectively

33

Table 5. Depositors risk sensitivity

Constant
NSA-1
Capital-1
ROA
Size
Liquidity

Deposit Growth
OLS
2SLS
-0.028
-0.044
(-7.751)***
(-1.132)
-0.072
-0.127
( -6.149)***
(-6.438)***
0.036
0.026
(1.954)*
(0.861)
0.043
0.049
(4.755)***
(3.183)***
0.012
0.007
(6.974)***
(2.523)**
0.033
0.037
(7.248)***
(4.690)***

Uninsured Deposit
OLS
2SLS
0.461
0.655
(13.166)***
(3.958)***
-0.072
-0.272
(-4.359)***
(-2.356)**
0.617
0.654
(25.605)
(6.242)***
0.087
0.039
(5.367)***
(0.535)
-0.018
-0.027
(-8.438)***
(-2.796)***
-0.036
-0.029
(-6.115)***
(-1.126)

Deposit
Interest

0.002
(0.946)

-0.183
(-7.585)***

0.000
(0.063)

-0.691
(-2.141)**

Interest
Rate
GDP

0.010
(2.707)***
0.001
(0.806)

-0.005
(-1.732)*
0.002
(1.123)

5,085
0.077
24.400***

4,920
0.029
18.998***

0.002
(0.493)
0.000
(0.198)
-0.028
(-1.544)
5,085
0.195
60.445***

-0.004
(-0.351)
-0.001
(-0.070)
0.024
(0.267)
4,920
0.012
6.884***

Deposit
Growth
n
Adj. R2
F

Notes:
a The year dummy variables are included as regressors, although their estimates are not
reported.
b The number in parentheses is the t-statistic computed using heteroskedasticity-robust
standard errors.
c ***, **, and * denote the significance levels of 1%, 5%, and 10%, respectively.

34

Table 6. The estimated effects of regulatory forbearance on depositors risk sensitivity

Deposit Growth c

Uninsured Depositc

Constant
D1 b

-0.244
-0.011

(-7.611)***
(-0.928)

0.457
-0.033

(13.029)***
(-2.018)**

NSA-1

-0.062

(-5.118)***

-0.079

(-4.611)***

D1*NSA-1

-0.025

(-0.609)

0.161

(2.492)**

Capital-1

0.016

(0.851)

0.626

(24.956)***

D1*Capital-1

0.138

(1.557)

-0.053

ROA

0.042

(4.597)***

0.083

(5.091)***

Size

0.011

(5.856)***

-0.018

(-8.341)***

Liquidity

0.032

(6.829)***

-0.033

(-6.051)***

Deposit Interest

0.002

(0.983)

0.000

(0.042)

Interest Rate

0.010

(2.678)***

0.003

(0.628)

GDP

0.001

(0.818)

0.000

(0.064)

-0.026

(-1.428)

Deposit Growth
n

5,085
2

Adj. R
F

(-0.307)

4,920

0.078

0.196

21.389***

52.285***

Notes:
a The existence of regulatory forbearance (D1) is one for the three quarters around the supervisory
measures if the regulatory action is forbearance and zero otherwise.
b The year dummy variables are included as regressors, although their estimates are not reported.
c The number in parentheses is the t-statistic computed using heteroskedasticity-robust standard errors.
d ***, **, and * denote the significance levels of 1%, 5%, and 10%, respectively.

35

Table 7. The estimated effects of regulatory forbearance on depositors risk sensitivity of

neighboring healthy banks
Deposit Growth b

Uninsured Depositc

Constant
D2

-0.344
0.021

(-5.233)***
(1.783)*

0.443
-0.056

(5.497)***
(-3.202)***

NSA-1

-0.010

(-0.316)

-0.156

(-2.193)**

D2*NSA-1

-0.038

(0.995)

0.101

(1.752)*

Capital-1

0.202

(3.180)***

0.551

(5.886)***

D2*Capital-1

-0.148

(-1.954)*

-0.055

(-0.496)

ROA

0.040

(2.491)**

0.080

Size

0.012

(3.754)***

-0.014

(3.162)***

Liquidity

0.001

(0.099)

-0.039

(-2.552)**

-0.033

(-0.401)

-0.319

(-1.802)*

Deposit Interest

(2.560)**

Interest Rate

0.024

(2.962)***

0.012

(0.963)

GDP

0.010

(0.099)

0.005

(0.960)

-0.044

(-1.201)

Deposit Growth
n
Adj. R2
F

2,838
0.160
12.071***

2,838
0.129
12.147***

Notes:
a The sample consists of healthy banks whose neighbor banks are subject to regulatory enforcement
or forbearance. The existence of regulatory forbearance (D2) is one if the number of forborne
banks exceeds that of enforced banks within the same business region of each healthy bank and
zero otherwise.
b The year dummy variables are included as regressors, although their estimates are not reported.
c The number in parentheses is the t-statistic computed using heteroskedasticity-robust standard errors.
d ***, **, and * denote the significance levels of 1%, 5%, and 10%, respectively.

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