This is an empirical study that examines how the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 in the U.S. banking industry affects the moral hazard risk-taking incentives of banks. We find that FDICIA appears to be effective in significantly reducing the systematic risk-taking incentives of the banks. Considering that the banks' asset portfolios are necessarily largely systematic risk-related, the significant decrease in their systematic risk-taking incentives provides some evidence of the effectiveness of FDICIA. However, with respect to the nonsystematic risk-taking behavior, the results generally indicate statistically insignificant decreases in the risk-taking incentives after FDICIA. To well-diversified investors who can diversify nonsystematic risk away, nonsystematic risk may not be a risk any more. However, to maintain a sound banking environment and to reduce the risk to individual banks, this result implies that regulatory agents should monitor the banks’ nonsystematic risk-taking behavior more closely, as long as it is positively related to the banks’ failures. We further test the change in the risk-taking incentives by partitioning the full sample into two groups: Banks with higher moral hazard incentives as those with larger asset size and lower capital ratio and banks with lower moral hazard incentives as those with smaller asset size and higher capital ratio. The main result for this test is that, with FDICIA, the decrease in the risk-taking incentives of the banks with higher moral hazard incentives (larger asset-size and lower capital-ratio banks) is less than that of the banks with lower moral hazard incentives (smaller asset-size and higher capital-ratio banks), with respect to both systematic and nonsystematic risk-taking measures. Furthermore, the change in the nonsystematic risk-taking incentives of the banks with higher moral hazard incentives is rather mixed, while their systematic incentives are decreased. These findings imply that the regulatory agents should allocate more time and effort toward monitoring the banks with higher moral hazard incentives with particular emphasis on their nonsystematic risk-taking behavior.
Dilemma of deposit insurance policy in ASEAN countries: Does it promote banking industry stability or moral hazard?