Do Depositors Respond to Bank Risks as Expected? Evidence from Japanese Financial Institutions in the Banking Crisis

This study analyzes a panel of nearly 800 deposit-taking institutions in Japan during the period from March 1992 to March 2003. 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. The empirical results obtained in this paper clearly show that Japanese depositors in the 1990s responded to the risks of financial institutions as expected: riskier institutions attract smaller amounts of deposits and are required to pay higher deposit rate. Moreover, the observed risk sensitivities are larger for international bank depositors and smaller for cooperative depositors, and continued to increase until a setback at March 2003. These findings were generally in line with the standard theory predictions. They also indicate that Japanese depositors have a disciplinary nature, and that the discipline is 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 depositor discipline. Key words: depositor discipline, banking crisis, financial institution JEL Classification: G21, G32