deregulation, reregulation, equity ownership, and s&l risk-taking

Deregulation, Reregulation, Equity Ownership, and S&L Risk-TakingAuthor(s): A. Sinan Cebenoyan, Elizabeth S. Cooperman and Charles A. RegisterSource: Financial Management, Vol. 24, No. 3 (Autumn, 1995), pp. 63-76Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665558 .

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Deregulation, Reregulation, Equity Ownership, and S&L Risk-Taking A. Sinan Cebenoyan, Elizabeth S. Cooperman, and Charles A. Register

A. Sinan Cebenoyan is Chair and Associate Professor of Finance, and Elizabeth S. Cooperman is Associate Professor of Finance, both at the University ofBaltimore, Baltimore, MD. Charles A. Register is Professor of Finance at Mississippi State University, Mississippi State, MS.

This study examines the relation between equity ownership composition and insolvency risk for savings and loans (S&Ls). We hypothesize that the effect of manager/stockholder alignments on bank risk-taking is contingent on the trade-off between stockholders' incentives for risk provided by deposit insurance subsidies and their disincentives based on the regulatory price for risk imposed under alternative regulatory regimes. In support of this hypothesis, we find that S&Ls with a high concentration of managerial stock ownership exhibit greater risk-taking behavior than other S&Ls in 1988, a period of regulatory leniency and forbearance on S&L closures, but lower risk-taking behavior in 1991, a period of regulatory stringency and nonforbearance. We also find S&Ls with greater institutional investor ownership to have lower insolvency risk than other S&Ls in 1991.

N Research on non-financial firms generally supports the hypothesis that corporate value is a function of the structure of equity ownership (Jensen and Murphy, 1990, and McConnell and Servaes, 1990). However, little research has been done on this issue for banks or savings and loans (S&Ls) (hereafter referred to generically as banks). For banks, this is a very important issue. Imprudent risk-taking behavior by manager/owners is often blamed for the S&L crisis and the $100 billion S&L bailout, as well as for the large number of bank failures that occurred in the late 1980s. In particular, Barth (1991) and Strunk (1991) point out that the removal of stockholder ownership concentration rules contributed to greater thrift risk-taking behavior by allowing manager/owners of S&Ls the potential for enormous returns on a small equity stake.1 Similarly, a number of

proposals to remove risk from the banking system assume that managerial/stockholder alignments result in greater bank risk-taking behavior.2

For banks, these relations are complex. First, bank shareholders, like other stockholders, may have incentives for greater risk-taking to maximize the value of their call option on the residual value of the firm (Galai and Masulis, 1976). Second, bank shareholders may have an additional incentive for risk-taking to maximize the value of their put-option subsidy on deposit insurance (Marcus and Shaked, 1984, and Merton, 1977). Bank managers, in contrast, may have incentives to engage in greater risk-reducing behavior to protect their own undiversifiable employment risk (Amihud and Lev, 1981). Hence, any mechanism that aligns the interests of managers to those of shareholders, such as significant managerial stock ownership, may result in greater bank risk (Saunders, Strock, and Travlos, 1990).

The authors are particularly grateful to an anonymous referee and to Glenn Wolfe for help and suggestions. The authors also benefited from comments from Douglas Evanoff, Barry Van Roden, Anoop Rai, Robert Cooperman, and session participants at a research seminar at the University of Baltimore and the 1993 and 1994 Financial Management Meetings. Murat Vanli, Renee Couto, and Cora Beisner provided excellent research assistance. Financial support from the Merrick School of Business at the University of Baltimore is also gratefully acknowledged. 1Prior to April 1982, an S&L located in a county with a population greater than 100,000 was required to have at least 400 shareholders. No individual could own more than 10% of the S&L's stock. Firms could own no more than 25%. Also, 75% of all stockholders had to live or do business in the S&L's market area. These restrictions were eliminated after April 1982, allowing single stockholders or stockholder/managers the opportunity for a phenomenal return on a small equity investment (see Barth, 1991).

2The Federal Deposit Insurance Improvement Act of 1991 (FDICIA) mandated the creation of a special committee to examine the link between bank managerial compensation and bank risk. This mandate was based on the assumption that managerial/shareholder alignments result in greater bank risk-taking behavior. Many financial economists contend that for any highly levered firm an alignment of manager and shareholder interests results in risk-shifting at the expense of debtholders. John and John (1993), for instance, suggest that higher capital requirements should be imposed for banks that have manager/shareholder alignments. Kane (1989) argues that a reduction in the limited liability of shareholders may be necessary to reduce risk-taking of stockholders incentives under a risk-insensitive deposit insurance system.

Financial Management, Vol. 24, No. 3, Autumn 1995, pages 63-76.



64 FINANCIAL MANAGEMENT / AUTUMN 1995

Institutional investors, as trustees acting under "prudent man" provisions may prefer less risk. However, given the " opaque" nature of banking, they may have little ability to monitor managers (Ross, 1989, and Zeckhauser and Pound, 1990).

Marcus (1984) argues that although bank shareholders have incentives to increase the value of their deposit insurance subsidy with greater risk-taking, they also have a

strong incentive to protect against loss of a bank's valuable charter and its accompanying rents. Keeley (1990) and Marcus (1984) demonstrate that banks with positive charter values are better capitalized and have lower default risk than other banks. Similarly, Jensen and Murphy (1990) and Theobold (1992) argue that in a regulatory environment in which banks are allowed to fail, bank managers with a large equity stake are more likely to exhibit more prudent behavior, since they have significant personal wealth at risk. Hence, some banks, such as Continental Illinois, mandate that managers have significant stock holdings.3

A bank's regulatory environment may also affect the

risk-taking proclivities of stockholders (Brickley and James, 1986; Buser, Chen, and Kane, 1981; Marcus, 1984; and Saunders, Strock, and Travlos, 1990). In a lenient

regulatory environment with forbearance on bank closures, shareholders have the potential for unlimited returns on

risky ventures and limited downside risk with a low

probability of closure enhancing the value of their call/put options. In a stringent environment with mandated closure for less solvent banks, however, the upside potential for

gains on riskier investments and the value of stockholders'

call/put options are truncated by a higher probability of closure associated with greater risk-taking. Thus, stockholders' risk-taking incentives and the effect of

management/stockholder alignments on bank risk may depend on the trade-off between regulatory subsidies that rise in value with greater risk-taking and the price imposed for risk by regulators under different regulatory regimes. We refer to this as the managerial alignment/regulatory regime hypothesis.

Two studies examine the relation between managerial stock ownership and bank risk with mixed results. Saunders, Strock, and Travlos (1990) (SST) find a linear relation between the managerial equity holdings of large bank holding companies (BHCs) in 1978-1985 and their stock price volatility. For the 38 very large BHCs that SST

examine, Mullins (1991) finds the same relation in 1986 but no relation for a larger sample of 78 BHCs. SST also test the hypothesis that the risk-taking incentives of bank stockholders rise during a period of relatively greater deregulation and regulatory forbearance on bank closures, defined (using a switching regression) as 1979-82. Consistent with this hypothesis, SST find a stronger relation between managerial ownership and BHCs' unsystematic risk in 1979-82 relative to 1978 and 1983-1985.

Although these studies provide valuable insights, by using BHC stock market data in the early to mid-1980s, they are limited in several respects. First, bank stock market risk measures in the early to mid-1980s may reflect difficulties that banks had adjusting to interest-rate volatility, the

primary cause of bank failures during this time period, as

opposed to risk-taking strategies per se. Failures relating to risk-taking strategies for assets dominated in the late 1980s, as risky loans soured (Kidwell, Peterson, and Blackwell, 1993). Also, by using BHC stock market data, these studies exclude smaller, more closely held banks that have more concentrated managerial ownership. Allen and Cebenoyan (1991), for instance, find a cutoff point for a high managerial stake for the 58 largest BHCs (with mean assets of $13.2 billion) to be just 0.7% of all outstanding shares. In contrast, smaller banks and S&Ls have a much higher range of managerial ownership concentration to examine.

Second, by using a bank sample, a test for a change in stockholders' risk-taking incentives in a period of forbearance on bank closure rules cannot be made. With the exception of the FDIC's rescue of Continental Illinois in 1984, regulators showed little forbearance in the 1980s over bank closure rules, closing over 1,080 banks.4

During SST's period of greater regulatory forbearance (1979-1982), the FDIC closed over 74 banks, including the first liquidation of a large bank, Penn Square, in July 1982

(Hempel, Simonson, and Coleman, 1994). SST's switching regression more likely captures the rise in bank stock

price volatility that occurred during 1979-1982 in response to the Fed's operating policy change away from targeting interest rates.

Finally, these studies do not examine whether the relation between risk-taking and managerial ownership holds during periods of regulatory stringency. Also, they do not examine the effect of institutional investor ownership on bank risk-taking behavior.

3Supporting this view, Jensen and Murphy (1990) find evidence that firms with insider holdings of 20% or higher focus more on long-term profits and shareholder value as objectives, while firms with lower managerial holdings focus on corporate growth. Theobold (1992) also cites a recent study of the 50 banks in the Salomon Bank index by Continental Bank that finds lower risk for banks with a higher percentage of corporate inside ownership.

4Regulators implicitly followed a "too big to fail" policy, but only for the nation's eleven largest banks, as noted by the Comptroller of the Currency in Congressional hearings on the rescue of Continental Illinois in 1984. (See O'Hara and Shaw, 1990).



CEBENOYAN, COOPERMAN & REGISTER / REGULATION, EQUITY OWNERSHIP, AND S&L RISK-TAKING 65

In this study, we provide a much stronger test for the hypothesis of a change in stockholders' risk-taking incentives under alternative regulatory regimes. We do this by examining, instead, the relation between equity ownership and risk for S&Ls in 1988, a period of extreme

regulatory forbearance, and 1991, a contrasting period of

regulatory stringency. In contrast to banks, regulators practiced extreme forbearance on S&L closure rules in the 1980s. As noted by Kaufman (1995, p. 195), by 1989 "close to 1,000 or one-third of all S&Ls, with half of the $1.2 trillion total assets in the industry, were

economically insolvent or close to it." S&Ls also were given very minimal capital requirements relative to banks.5

Since evidence of S&L risk-taking did not fully come to light until the late 1980s, we select 1988, the

peak of the S&L crisis, to examine. For S&Ls, there is also a clear demarcation of a counter period of

regulatory stringency and nonforbearance with the passage of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. FIRREA mandated that regulators close all severely undercapitalized S&Ls. S&Ls' range of asset choices was also restricted, and S&Ls were required to meet capital standards comparable to those commercial banks had to meet.6 We select 1991, the first year in which FIRREA's mandates were fully implemented as the

period to examine. In contrast to previous studies that used market risk measures, we use a probit model to examine the relation between equity ownership and the probability that an S&L will be technically insolvent.

Consistent with a managerial alignment/regulatory regime hypothesis, we find evidence of greater risk-taking behavior for stockholder-controlled S&Ls as compared to

managerial-controlled S&Ls in 1988, and we find the

opposite relation in 1991. We also find lower

insolvency risk for S&Ls with greater institutional investor

ownership in 1991. The remainder of the paper is organized as follows.

Section I provides background on the relation between

equity ownership structure and insolvency risk. Section II describes the empirical test design and the data used in the

study. Section III contains the empirical results, and Section IV furnishes conclusions.

I. Equity Ownership Structure and Bank/Thrift Insolvency Risk

Buser, Chen, and Kane (1981) demonstrate that in the absence of agency costs of debt by depositors and

regulatory constraints, bank shareholders benefit from taking on increasing amounts of financial leverage and riskier bank assets. Managers, as agents, however, are generally assumed to prefer to protect their own undiversifiable

employment risk (Amihud and Lev, 1981). Managerial equity ownership, however, may align the interests of

managers to those of external shareholders, which may result in greater risk-taking behavior.

A. Regulatory Regimes and Stockholder Risk Preferences Marcus (1984) points out that the standard view that

bank shareholders will take on excessive risk to exploit their options at the expense of debtholders and the insurer ignores the trade-off of an increase in the probability of bank closure by regulators and, hence, the loss of a bank's valuable charter and its associated economic rents. He demonstrates that for banks with low charter values, the trade-off weighs heavily towards risk-taking since these banks have little to lose. For banks with high charter values, the trade-off weighs more heavily towards risk-reducing behavior, such as adding capital, to protect a bank against insolvency. In a deregulated environment with ease of entry and forbearance on closure, however, Marcus points out that loss of charter value no longer provides a deterrent against excessive risk-taking. Brickley and James (1986) similarly point out that during periods of regulatory forbearance on bank closure rules, banks receive an additional subsidy in terms of a continued risk-free cost of debt despite a bank's technical insolvency. Hence, the present value of this subsidy rises in value for banks with greater insolvency risk.

In contrast, Buser, Chen, and Kane (1981) demonstrate that in periods of regulatory stringency and nonforbearance, regulators set a high price for risk-taking in terms of greater regulatory interference and expedient closure. Additional access to deposit insurance that less solvent banks received under regulatory forbearance is eliminated. Thus, stockholders have stronger disincentives for risk-taking in terms of preventing greater regulatory interference and greater incentives for risk-reducing behavior to protect their bank's charter value.

5In 1988, of approximately 2,949 S&Ls, 250 S&Ls were insolvent by regulatory standards, 372 by GAAP standards, and 508 based on tangible capital, after deducting goodwill and other intangibles from GAAP net worth (see Cordell, MacDonald, and Wohar, 1993). As pointed out by Kane (1989), the FSLIC was economically insolvent as early as 1984, if accumulated and projected losses were reported in the GAO's estimate. See Brickley and James (1986) for a summary of the FSLIC's policies of forbearance, including numerous regulatory accounting gimmicks.

6FIRREA also imposed a qualified thrift lender test, whereby home-mortgage related assets had to be at least 70% (later reduced to 65%) of a thrift's assets. State-chartered S&Ls in more liberally-regulated states, which had previously allowed direct equity investments, were now required to meet the same regulatory standards as federally-chartered S&Ls. S&Ls were also required to divest their junk bond holdings.




Based on these arguments, the effect of any alignment between managers and stockholders, such as greater managerial ownership on bank risk-taking behavior, depends on the trade-off between insurance subsidies that rise in value with greater bank risk and the price for risk imposed by regulators under alternative regulatory regimes. This managerial alignment/regulatory regime hypothesis implies that during periods of deregulation and regulatory forbearance, manager/shareholder alignments, such as high managerial equity ownership, should result in greater bank risk-taking behavior. However, during periods of nonforbearance, with a high penalty (expedient closure) associated with greater risk-taking, stockholders have stronger risk-reducing incentives, closer to those of

managers. Consequently, as managers' ownership stake rises, banks should engage in greater risk-reducing behavior.

B. Institutional Investors and Risk-Taking Preferences

For non-financial firms, previous research finds a

significant positive relationship between firm performance and the fraction of equity held by institutional investors (see McConnell and Servaes, 1990). These results are consistent with Pound's (1988) efficient monitoring hypothesis whereby institutional investors, as large blockholders, have greater expertise, resources, incentives, and power to monitor investments than other shareholders.

Institutional investors may also be more restricted by contractual arrangements in their ability to diversify than other shareholders. As trustees acting under "due diligence" and "prudent man" provisions, they have a greater duty to ensure the safety of their investments and so have a stronger mandate to monitor managers and, in particular, a depository institution's insolvency risk. Bathala, Moon, and Rao (1994) find a significant inverse relationship between the debt ratios of non-financial firms and equity holdings by institutional investors supporting this contention.

Alternatively, Ross (1989) and Zeckhauser and Pound (1990) point out that for "opaque" institutions, the decisions of managers cannot be observed by external shareholders. Hence, institutional investors of banks/thrifts have little

ability to monitor managerial decision-making. Ross (1989) points out that this is particularly the case for depository institutions, since managerial decisions are typically confidential, such as the riskiness of particular loans.

II. Empirical Procedures Based on the previous discussion, we examine the

relation between equity ownership composition and S&L insolvency risk.

A. The Model We estimate the following probit model using a maximum

likelihood technique (see Judge, Hill, Griffiths, Lutkepohl, and Lee, 1982) to test the managerial alignment/regulatory regime hypothesis:

INSOLVENCY = f(INSIDE, OUTSIDE, (1) SIZE, LIB, UNEMP)

where INSOLVENCY is a risk measure for each individual S&L. Similar to SST (1990), we assume that, in the short term at least, the level of risk can be viewed as an endogenous decision variable for an S&L affected by its ownership structure, other control variables, and regulatory regimes.

INSIDE is the percentage of equity held by managers/directors of an S&L. OUTSIDE is the percentage of equity held by institutional investors. SIZE is the asset size of an S&L. LIB is a control variable for state

regulatory factors. UNEMP is a control variable for regional economic factors.

B. The Dependent Variable The variables in Equation (1) are described as follows.

INSOLVENCY is a dichotomous variable, which is

equal to 1 if an S&L's equity-to-asset (or core capital) ratio is below the 3% regulatory minimum and 0 otherwise.7 We focus on this measure of insolvency risk for two reasons. First, many S&Ls, although publicly traded, are closely held and infrequently traded. Consequently, market risk measures may be unreliable, since a lack of price volatility may reflect infrequent trading rather than high bankruptcy risk. Similarly, eliminating these S&Ls from the sample creates a sampling bias. Second, from the perspective of

greater regulatory forbearance, we wish to examine the risk of an S&L's capital ratio falling below minimum

acceptable levels, which would imply technical insolvency in 1988 and the risk of closure (actual insolvency) in 1991. Other studies that have examined factors affecting insolvency risk have used a similar dichotomous variable (see Cole, 1993 and Demirguc-Kunt, 1989).

To provide sensitivity tests for our insolvency risk measure, we also perform cross-sectional regressions

7Under recent regulations, depository institutions' equity- capital-to-assets (core capital) ratios place them in one of five target zones, with 3% or less indicating significant undercapitalization. S&Ls with equity less than 2% are considered to be critically undercapitalized (and eligible to be placed in receivership or conservatorship within 90 days). In the 1980s, S&Ls faced more lenient capital regulations but were considered to be technically insolvent if their tangible equity capital ratios fell below a regulatory minimum of 3%. For a review of the capital requirements under FIRREA of 1989, see Barth (1991), and for the requirements under FDICIA of 1991, see Saunders (1994).




using alternative risk measures: 1) CAPITAL, an S&L's

equity-to-assets ratio; 2) REPOS, an S&L's percentage of repossessed assets to total assets; and 3) CAEL, a

composite risk rating created by Sheshunoff S&L Information Services.8 Sheshunoff constructed this measure to approximate regulators' CAMEL ratings, excluding the " M," a measurement of management quality. This rating is based on a weighted average of the following four risk measures: 1) capital adequacy (tangible capital to

assets); 2) asset quality (nonperforming loans and

repossessed assets to total assets); 3) earnings (return on

assets); and 4) liquidity (liquid assets as a percentage of total liabilities). These factors are weighted by their relative

importance based on Sheshunoff's Annual Bank President's

Survey on Bank Safety and Soundness. The scores are ranked on a nationwide basis from 0 to 99, with 99 as the best

possible performance score.

C. The Independent Variables We measure the degree of manager ownership (INSIDE)

of an S&L as the percentage of stock held by S&L managers and directors. We measure the degree of institutional investor

ownership (OUTSIDE) as the percentage of stock held by institutional investors.

Under the managerial alignment/regulatory regime hypothesis, S&Ls with greater managerial ownership should exhibit greater risk-taking behavior in periods when

regulatory costs are low and greater risk-reducing behavior in periods when regulatory costs are high. Thus, we expect S&Ls with a higher concentration of managerial ownership to have greater insolvency risk in 1988 but lower insolvency risk in 1991.

It may be that relatively higher levels of managerial ownership may be needed to align the interests of shareholders and managers. At lower levels of ownership, managers' interests may not be aligned with external shareholders; rather managers may have sufficient voting power to act in their own utility-maximizing interests, such as preserving their own undiversifiable employment risk (Demsetz, 1983, and Williamson, 1963). Hence, a nonlinear relation between managerial ownership and

risk-taking behavior may exist (McConnell and Servaes, 1990). Since McConnell and Servaes and others find the relationship between nonfinancial firm performance and insider ownership to be nonlinear, we use lagrange multiplier tests (see Ramanathan, 1992, p. 313) to determine

whether the squared value of INSIDE, INSIDESQ, should be included in the model.

Since we expect institutional investors to be more risk averse and to have stronger incentives and greater ability to monitor managers than other stockholders, we expect a

significant negative relationship between risk measures and OUTSIDE.

Because data on large non-institutional blockholders were not included in the data collected for outside

ownership by SNL Securities, OUTSIDE excludes other

large blockholders. Consequently, our measure may underestimate the effect of large external shareholders on S&L risk taking.

D. The Control Variables As suggested by SST (1990), larger S&Ls may have a

greater potential to diversify or may have greater access to capital markets, which could reduce an S&L's insolvency risk. On the other hand, investors may assume that regulators will not allow the very largest S&Ls to fail, and so these S&Ls may take on greater risk. Since this suggests a nonlinear relation, we use lagrange multiplier tests to determine whether the squared value of size (SIZESQ) should be included for each model in each year.

To control for state regulations that allow more

risk-taking activities, which might lead to greater insolvency risk, we include LIB, a dummy variable for state-chartered S&Ls operating in more liberally-regulated states (California, Florida, Louisiana, Ohio, and Texas). (See Benston, 1985). Since opportunities for risk-taking for state-chartered S&Ls were reduced under FIRREA, we expect a positive, significant coefficient for LIB

only for 1988. We include UNEMP, a state's unemployment rate, to

control for regional economic conditions that may affect an S&L's insolvency risk, as observed in various studies of S&L/bank closures (see Cebenoyan, Cooperman, and Register, 1993, and Demirguc-Kunt, 1989). If S&Ls in financially distressed areas face greater insolvency risk, we would expect a positive coefficient for UNEMP.

E. The Data

We select representative years, 1988 and 1991, for each regulatory regime for our comparison. We select 1988 as a period of deregulation and regulatory forbearance on S&L closure rules for several reasons. 1) It provides the earliest year with published ownership data available for S&Ls. 2) It represents the peak of the S&L crisis of the 1980s, a year in which S&L loans soured and evidence of risky behavior for S&Ls became apparent. 3) By occurring a year

8See Sheshunoff S&L Quarterly: Ratings and Analysis (December 1988 and December 1991) for a more detailed description of these ratings. This analysis is published by Sheshunoff Information Services, Inc.




prior to FIRREA, it allows us to examine a larger subsample of common S&Ls with a fairly stable equity ownership composition before and after the implementation of FIRREA. 4) It offers us the largest sample of pre-FIRREA stock-chartered S&Ls to examine, which had been operating as stock S&Ls for at least three years. We restrict our sample to S&Ls that had stock charters for three years or more so as to avoid any bias associated with three-year limitations

placed on managerial ownership for S&Ls converting to stock charters after 1980.9

From the period of stringent regulation and nonforbearance we select 1991 for similar reasons. 1) It

represents the first full year following the full

implementation of FIRREA, which mandated closure of S&Ls that did not comply with new capital requirements.10 2) It provides the largest common subsample of S&Ls to examine for both years. For instance, by 1992, as the result of further S&L closures and mergers, the number of S&Ls in the country had fallen by 13%. 3) It is close

enough to 1988 that the equity ownership composition for the common subsamples changed very little. This allows a

stronger test of our hypothesis by permitting us to examine the effect of equity ownership composition on S&Ls'

recapitalization between 1988 to 1991.

Ownership data comes from the SNL Quarterly Thrift Digest. Insider ownership data are based on 13D, 13G, and

F11 filings with the SEC, FDIC, or OTS, as supplemented by the beneficial ownership information disclosed in proxy filings. Institutional investor ownership data are compiled from 13F filings. Unemployment rates are from the U.S. Bureau of the Census, Statistical Abstract of the U.S., Washington, D.C., 1989, 1992. Balance sheet and income statement data come from the FHLBB data tapes. We restrict our sample to S&Ls with data available on the FHLBB data

tapes and with ownership data available in the SNL Quarterly Thrift Digest.

Our final sample includes 86 stock-chartered S&Ls in 1988 and 189 in 1991. As large publicly-traded S&Ls, these thrifts hold a significant share of the total assets for the thrift industry. The larger sample in 1991 reflects the fact that about 183 S&L conversions occurred in the mid-1980s (see Cordell, MacDonald, and Wohar, 1993).

Between 1989 and 1991, 22 of the 86 S&Ls in the 1988 sample were closed by regulators, 14 were merged with other non-sample S&Ls or commercial banks, and 3 no longer had ownership data provided in the SNL Quarterly Thrift Digest. This leaves a subsample of 47 surviving S&Ls that are common to both 1988 and 1991. However, since this subsample includes relatively less risky (surviving) S&Ls, it incorporates a survivorship bias. An unavoidable survivorship bias also exists for any S&Ls examined after 1988, since regulators began closing severely undercapitalized S&Ls in 1989. Keeping this in mind, we examine the relationship between risk-taking behavior and equity ownership for the entire samples of S&Ls in 1988 and 1991. To test the sensitivity of our results, we also examine the common subsample including the effect of equity ownership on changes in S&L risk-taking between 1988-1991 and 1991-1993. Because of mergers, the size of this subsample decreases to 40 S&Ls for these later regressions.

Ill. Empirical Results This section furnishes our empirical results.

A. Descriptive Statistics Table 1 provides the descriptive statistics for the 1988 and

1991 samples. As expected, the mean of INSOLVENCY is

significantly lower in 1991 (37.2% insolvent S&Ls in 1988 vs. 13.2% in 1991), and the mean CAPITAL ratio is

significantly higher (3.66% in 1988 vs. 6.05% in 1991), reflecting a more stringent regulatory environment under FIRREA. The means of CAPITAL for the solvent S&Ls are respectively 5.21% in 1988 and 6.67% in 1991. This contrasts with means of 0.77% in 1988 and 1.99% in 1991 for the less solvent S&Ls. Thus, there is a wide gap in terms of capitalization between less solvent and solvent S&Ls for each year.

In contrast to a lower mean for INSOLVENCY and higher mean for CAPITAL, indicating lower risk taking in 1991, the mean for REPOS is significantly higher in 1991 than in 1988. This reflects writedowns of large volumes of bad loans regulators mandated in 1991. Thus, the 1991 REPOS measure reflects the results of earlier behavior rather than the current behavior of managers in 1991. CAEL (which is heavily weighted by REPOS) also may be somewhat biased in 1991. Since CAPITAL rose in

9As Cordell, MacDonald, and Wohar (1992) point out, after 1980 regulations for conversions prevented an alignment of the interests of managers and stockholders for a three-year period by incorporating an anti-takeover rule in which any beneficial ownership by an individual could be no more than 10% for any class of equity security for three years following conversion. They also point out that limits were placed on the amount of stock that could be offered during this period: 1) to 5% for any person or identified group and 2) to 15-25% for all officers and directors.

10See Barth (1991, p. 86). After January 1, 1991, S&Ls that did not meet new capital standards under FIRREA were required to submit a plan of compliance to the Office of Thrift Supervision, and mandatory restrictions were placed on asset growth. Limits were placed on 'the payment of dividends and compensation until the requirements were met. Regulators were required to close any critically undercapitalized S&L or any S&L that failed to comply with its submitted business plan. These regulations were not phased in until 1991.




Table 1. Descriptive Statistics

This table provides the descriptive statistics for the 1988 and 1991 samples. INSOLVENCY = dummy variable = 1 for severely undercapitalized S&Ls. CAPITAL = S&L's equity-to-asset ratio. REPOS = repossessed assets to total assets. CAEL = Sheshunoff performance ranking. INSIDE = percentage of stock held by officers and directors. OUTSIDE = percentage of stock held by institutional investors. SIZE = book value of assets. LIB = a dummy variable = 1 for state-chartered S&Ls in more liberally regulated states and 0 otherwise. UNEMP = the state unemployment rate.

Panel A. 1988 (N = 86)

Variable Mean Std. Dev. Minimum Maximum

INSOLVENCY 0.372 0.486 0.00 1.00 CAPITAL (%) 3.664 2.896 -2.91 12.11

REPOS (%) 0.911 1.085 0.00 5.29

CAEL 38.429 22.549 6.00 99.00

INSIDE (%) 20.793 13.802 2.10 59.30

OUTSIDE (%) 11.162 12.105 0.00 53.40

SIZE (in millions) 1815.600 2242.000 48.95 10520.00

LIB 0.116 0.322 0.00 1.00

UNEMP (%) 5.149 1.314 3.00 8.40

Panel B. 1991 (N = 189)

Variable Mean Std. Dev. Minimum Maximum

INSOLVENCY 0.132*** 0.340 0.00 1.00

CAPITAL (%) 6.054*** 3.039 -0.26 21.05

REPOS (%) 2.854*** 3.141 0.00 17.48

CAEL 38.577 26.559 1.00 99.00

INSIDE (%) 17.630 11.845 0.26 72.49

OUTSIDE (%) 12.833 15.806 0.00 83.20

SIZE (in millions) 1425.800 3657.700 78.18 37180.00 LIB 0.058 0.235 0.00 1.00

UNEMP (%) 5.332 0.771 2.80 8.30

***Significant at the 0.01 level.

1991, and CAEL is also heavily weighted by CAPITAL, the mean of CAEL in 1991 is similar to the mean in 1988.

Between 1988 and 1991, the means of INSIDE and OUTSIDE are not significantly different. The mean of INSIDE is about 21% in 1988 and 18% in 1991. The mean of OUTSIDE is 11% in 1988 and about 13% in 1991. With the larger sample in 1991, the respective ranges for INSIDE and OUTSIDE are wider than in 1988.11

For the sample, there is no significant difference in any of the control measures between 1988 and 1991. The S&Ls are

fairly large with a mean of $1.8 billion in 1988 and $1.4 billion in 1991. In contrast to the sample in 1988, very few of the S&Ls operated in liberally-regulated states in 1991, reflecting the fact that a large number of S&Ls operating in these states failed by 1991.12

"Wilcoxon signed rank tests indicated no significant change in the median for INSIDE (about 17% for both years) and the median for OUTSIDE (6.72% in 1988 and 7.9% in 1991) for the 47 common S&Ls. This suggests that the ownership composition for these S&Ls remained fairly stable.

12Relatively low correlations for the independent variables for the samples and subsamples in 1988 and 1991 suggested no significant multicollinearity. This was confirmed using an auxilliary regression technique on the independent variables (see Judge et al., 1982, p. 622).




Table 2. Insolvency and Capital Ratio Risk Measures by Quartiles According to Percentage of Corporate Insider Ownership This table examines the relationship between the percentage of insider ownership and the measures of insolvency risk and capital adequacy. % INSIDERS = percentage of equity held by all officers and directors. INSOLVENCY = the fraction of S&Ls in a quartile that have capital ratios below the regulatory minimum. CAPITAL = tangible equity-to-asset ratio.

Panel A. Quartiles for 1988 (N = 86)

INSOLVENCY CAPITAL

% INSIDERS N Mean Mean Median

0 to 9.75% 22 0.455 0.032 0.027

9.75 to 15.36% 21 0.286 0.044 0.035

15.36 to 21.37% 21 0.190 0.042 0.043

> 21.37% 22 0.455 0.030 0.030

Panel B. Quartiles for 1991 (N = 189)

INSOLVENCY CAPITAL

% INSIDERS N Mean Mean Median

0 to 9.75% 47 0.188 0.058 0.054

9.75 to 17.49% 47 0.152 0.068 0.062

17.49 to 21.59% 48 0.125 0.060 0.058

> 21.59% 48 0.083 0.057 0.055

B. Quartile Results

Table 2 examines the relationship between the percentage of insider ownership and INSOLVENCY and CAPITAL. For 1988 (Panel A), we find evidence of a nonlinear relation between insolvency risk and managerial ownership. Over the first three quartiles, as insider ownership rises, the

percentage of less solvent S&Ls falls. For the highest INSIDE quartile, however, the percentage of less solvent S&Ls rises dramatically from 19% to 45.5%. We do not see much variation in CAPITAL over the first three

quartiles, but we do find a sudden drop in CAPITAL for the

highest quartile. The pattern between insolvency risk and insider

ownership quartiles in 1988 indicates greater insolvency risk for S&Ls with a large managerial ownership stake at about 21% managerial ownership or higher. This is consistent with the premise that an alignment of the interests of managers and stockholders at higher ownership levels leads to greater risk-taking under lenient regulatory regimes. The fall in risk as inside ownership rises at lower insider

ownership levels suggests an entrenchment effect. Managers at lower ownership levels may have insufficient ownership to be aligned with the risk-taking incentives of external shareholders but may have sufficient ownership to act on

their own utility-maximizing preferences to protect their undiversifiable unemployment risk.13

As shown in Panel B, in 1991, a stringent regulatory regime, we find little variation on CAPITAL between

quartiles on insider ownership. However, we do see a

good deal of variation in the percentage of less solvent S&Ls across INSIDE quartiles, with a negative, linear relation between managerial ownership and INSOLVENCY. In contrast to 1988, this evidence indicates greater risk-reducing behavior for S&Ls with a larger concentration of managerial ownership in 1991, consistent with the

managerial alignment/regulatory regime hypothesis.

C. Probit Model Results

Our probit results, shown in Table 3 for 1988 and Table 4 for 1991, reveal the same respective relations between INSOLVENCY and INSIDE that we saw in the

quartile examination. Lagrange multiplier tests indicate a nonlinear relation on INSIDE in 1988 and a linear relation in 1991. Lagrange multiplier tests also indicate a

13The quartiles for the 47 common S&Ls on INSOLVENCY indicated a similar nonlinear relation between insolvency risk and managerial ownership in 1988. Regressions for the 47 on CAPITAL and change in CAPITAL are consistent with our probit model results in 1988 and 1991.




Table 3. Probit Model Estimates 1988

This table presents the results of the probit analysis for 1988. The dependent variable is INSOLVENCY, which equals 1 for Less Solvent and 0 for Solvent. INSIDE = the percentage of equity owned by all officers and directors. INSIDESQ = the squared value of insider holdings. OUTSIDE = the percentage of equity owned by institutional investors. SIZE = the book value of assets in thousands. LIB = a dummy variable = 1 for state-chartered thrifts operating in more liberally regulated states and 0 otherwise. UNEMP = the state unemployment rate. (t-statistics are given in parentheses beneath each coefficient).

Independent Variable Coefficients

Intercept -0.412 (-0.510)

INSIDE -0.098 (-2.226)**

INSIDESQ 0.002 (2.456)**

OUTSIDE -0.018 (-1.193)

SIZE (in thousands) 0.0003 (3.617)**

LIB 0.021 (0.042)

UNEMP 0.094 (0.764)

Log-Likelihood -42.030 N=86

***Significant at the 0.01 level. **Significant at the 0.05 level. *Significant at the 0.10 level.

linear relation on SIZE in 1988 but a nonlinear relation in 1991. For each year, our models have a good fit.

For the sample in 1988 (Table 3), we find a significant negative coefficient on INSIDE and a significant positive coefficient on INSIDESQ. Solving for the level of

managerial ownership that makes the total effect on insider ownership become positive, the turning point is 24.5%.14 S&Ls with managerial ownership greater than about 25% appear to have engaged in greater risk-taking behavior than S&Ls with lower managerial ownership. At lower managerial ownership levels, as managerial ownership rises, however, S&Ls exhibited lower insolvency risk. This is the same entrenchment effect that we find in the quartile examination. For the control variables, the coefficient of SIZE is positive and significant, suggesting greater insolvency risk for larger S&Ls in 1988.

For the sample in 1991 (Table 4), in contrast, as noted in the quartile examination, we see a significant negative linear relation between INSIDE and INSOLVENCY. This result is consistent with a risk-reducing effect of managerial ownership in 1991. If a nonlinear specification is used, the coefficients are insignificant. However, INSIDE is

positive, and INSIDESQ is negative, the opposite o f the

signs for the 1988 sample. We also find a significant negative coefficient on OUTSIDE. S&Ls with greater institutional investor ownership appear to have lower insolvency risk than other S&Ls in 1991.

For the control variables for the 1991 sample, the coefficient of SIZE is positive and significant, indicating greater insolvency risk for larger S&Ls. However, the coefficient of SIZESQ is significant and negative, showing a decline in risk for very large S&Ls.

In summary, our results for the probit models are similar to those of the quartile examination. We find evidence of greater risk-taking behavior for S&Ls with a large managerial equity ownership stake in 1988, with the opposite relation holding in 1991. We also find an

14The full effect on insider ownership for the nonlinear regression is equal to the coefficient on INSIDE plus two times the product of the coefficient on INSIDESQ and a given inside ownership level. Turning points are calculated by solving for the unknown managerial ownership level that makes this full effect equal to zero.




Table 4. Probit Model Estimates 1991

This table presents the results of the probit analysis for 1991. The dependent variable is INSOLVENCY, which equals 1 for Less Solvent and 0 for Solvent. INSIDE = the percentage of equity owned by all officers and directors. INSIDESQ = the squared value of insider holdings. OUTSIDE = the percentage of equity owned by institutional investors. SIZE = the book value of assets in thousands. LIB = a dummy variable = 1 for state-chartered thrifts operating in more liberally regulated states and 0 otherwise. UNEMP = the state unemployment rate. (t-statistics are given in parentheses beneath each coefficient).

Independent Variable Coefficients

Intercept 0.108 (0.121)

INSIDE -0.028 (-2.015)**

OUTSIDE -0.064 (-3.320)***

SIZE (in thousands) 0.001 (3.403)***

SIZESQ -0.002 x 10-5 (-1.916)*

LIB -0.381 (-0.533)

UNEMP -0.129 (-0.812)

Log-Likelihood -58.717 N= 189


entrenchment effect at lower corporate insider ownership levels in 1988. S&Ls with greater institutional investor

ownership also appear to have had lower insolvency risk in 1991.

D. Cross-Sectional Regression Results To test the sensitivity of our INSOLVENCY risk

measure, we perform additional cross-sectional regressions using the alternative risk measures described in the data section.

Our cross-sectional results for 1988 are shown in Table 5. Lagrange multiplier tests generally specify a nonlinear relation on INSIDE, similar to the probit model, with the exception of a linear relation for CAPITAL. For SIZE, lagrange multiplier tests specify a nonlinear relation for the CAPITAL regression and a linear relation for the other models.

For the REPOS regression, we find a significant negative coefficient on INSIDE and a positive coefficient on INSIDESQ. The turning point on managerial ownership is 38.5%. For the CAEL regression, we find this

same nonlinear relationship, with a turning point on inside

ownership of 31.5%. Similar to our probit model and quartile examination in 1988, these results indicate greater risk-taking for S&Ls with a higher concentration of insider ownership, with an entrenchment effect at lower insider ownership levels.

For the CAPITAL regression, we find a negative linear, but insignificant, relation between corporate insider ownership and CAPITAL. The insignificant relation is

expected, since we saw little variation in CAPITAL for the first three INSIDE quartiles in our quartile examination for 1988.

For all regressions, we find a significant coefficient on OUTSIDE indicating higher capital ratios, lower repossessed assets, and higher performance scores for S&Ls with greater institutional investor ownership in 1988. For the control variables, the results on SIZE for these regressions are similar to previous models.

Thus, the cross-sectional regressions in 1988 provide supporting evidence of greater risk-taking behavior for stockholder-controlled S&Ls, with an entrenchment




Table 5. Cross-Sectional Results for 1988

Generalized-least squares regression using White's (1980) adjustment for heteroskedasticity. CAPITAL = an S&L's equity-to-asset ratio. REPOS = repossessed assets to total assets. CAEL = a Sheshunoff performance ranking. INSIDE = the percentage of equity owned by all officers and directors. INSIDESQ = the squared value of insider holdings. OUTSIDE = the percentage of equity owned by institutional investors. SIZE = the book value of assets in thousands. LIB = a dummy variable = 1 for state-chartered thrifts operating in more liberally regulated states and 0 otherwise. UNEMP = the state unemployment rate. (t-statistics are given in parentheses beneath each coefficient).

Independent Variables Dependent Variable

(1) (2) (3) CAPITAL REPOS CAEL

Intercept 4.970 1.347 28.409 (3.635)*** (2.031)** (2.175)**

INSIDE -0.014 -0.077 1.441 (-0.574) (-2.155)** (2.652)**

INSIDESQ 0.001** -0.024 (2.154) (-2.712)***

OUTSIDE 0.056 -0.024 0.463 (2.048)** (-2.468)*** (2.056)

SIZE (in thousands) -0.002 -0.000 -0.002 (-4.451)*** (-0.293) (-2.109)**

SIZESQ 0.117 x 10-9 (3.260)***

UNEMP 0.070 0.138 -1.088 (0.352) (1.534) (-0.578)

LIBSTATE -0.826 0.380 -6.520 (-0.914) (0.850) (-0.851)

F-statistic 5.758*** 1.887* 2.134* N=86 N=86 N= 84


effect at lower ownership levels in 1988. The results also suggest that institutional investors had some effect in reducing S&L risk-taking as early as 1988, although the probit results indicate an insignificant effect on

insolvency risk. As shown in Table 6, similar to the probit model in

1991, lagrange multiplier tests indicate a linear relation between risk measures and managerial ownership for each model. Lagrange multiplier tests also indicate a similar nonlinear relation on SIZE for all models except for the regression on REPOS. As we expected, the model for REPOS provides little explanatory power because REPOS represents risk-taking behavior from previous years.

For the CAPITAL regression, we find a positive linear, but insignificant, relation between INSIDE and CAPITAL. This is consistent with the quartile examination in 1991, which showed little variation in CAPITAL across quartiles

on corporate insider ownership. For the CAEL and CAPITAL regressions, we find higher performance scores and higher capital ratios for S&Ls with greater institutional investor ownership, consistent with our probit results in 1991. The results on SIZE for these regressions are similar to the results for the probit model in 1991.

IV. Summary and Conclusion We investigate the relation between equity ownership

structure and insolvency risk for S&Ls in 1988, a period of deregulation and forbearance, and 1991, a period of reregulation and mandated closures of less solvent S&Ls. We test a managerial alignment/regulatory regime hypothesis that predicts that the incentives of stockholders for risk-taking depend on the trade-off between the value of insurance subsidies that rise with risk-taking and the price for risk imposed by regulators.




Table 6. Cross-Sectional Results for 1991

Generalized-least squares regression using White's (1980) adjustment for heteroskedasticity. CAPITAL = an S&L's equity-to-asset ratio. REPOS = repossessed assets to total assets. CAEL = a Sheshunoff performance ranking. INSIDE = the percentage of equity owned by all officers and directors. INSIDESQ = the squared value of insider holdings. OUTSIDE = the percentage of equity owned by institutional investors. SIZE = the book value of assets in thousands. LIB = a dummy variable = 1 for state-chartered thrifts operating in more liberally regulated states and 0 otherwise. UNEMP = the state unemployment rate. (t-statistics are given in parentheses beneath each coefficient).

Independent Variables Dependent Variable

(1) (2) (3) CAPITAL REPOS CAEL

Intercept 0.042 0.259 -2.896 (3.656)*** (0.148) (-0.233)

INSIDE 0.0001 0.027 0.051 (0.356) (0.833) (0.385)

OUTSIDE 0.001 -0.013 0.809 (4.049)*** (-0.866) (5.583)***

SIZE (in thousands) -0.924 x 10-5 -0.491 x 10-5 -0.007 (-5.964)*** (-0.106) (-4.464)

SIZESQ 0.215 x 10-1 0.141 x 10-9 (4.991)*** (3.405)***

UNEMP 0.004 0.449 6.982 (1.649)* (1.579) (2.991)***

LIBSTATE 0.004 -1.591 6.979 (0.493) (-1.980)** (0.960)

F-statistic 6.940*** 1.26 8.153*** N= 189 N= 189 N= 189


Consistent with this hypothesis, we find that S&Ls with greater managerial equity ownership (greater than approximately 25%) have greater insolvency risk than S&Ls with lower managerial holdings in 1988. In 1991, however, we find a significant negative relationship between

managerial equity ownership and S&L risk-taking. We also find a significant negative relationship between institutional investor ownership and S&L's insolvency risk in 1991.

Our results for 1988 are similar to the risk-taking behavior that SST (1990) find for bank holding companies with higher insider ownership in the early to mid-1980s. However, unlike SST, we find evidence of an entrenchment effect at lower managerial ownership levels. Our results for 1991, an environment of regulatory stringency, are similar to those reported in previous studies of non-financial firms, which found positive effects of managerial ownership and institutional investor ownership on firm performance. For 1988, a regulatory environment of forbearance, however, institutional ownership had an insignificant effect on

insolvency risk, although we find that institutional investor

ownership had a positive effect on capitalization. Our empirical results support the contention that equity

ownership composition matters for depository institutions. Managers of S&Ls that are owned by institutional investors

appear to act more prudently than managers of other S&Ls.

Managers of S&Ls with significant equity stakes also exhibit more prudent behavior than managers of other S&Ls but only in a stringent regulatory environment in which thrifts are allowed to fail. In a lenient regulatory environment, manager/owners, in contrast, exhibit greater risk-taking behavior.

Our results imply that the new, more stringent closure rules under FIRREA for thrifts, and under the Federal Deposit Insurance Improvement Act (FDICIA) of 1991 for banks, should help to eliminate risk-taking incentives from the banking system. They also suggest that significant institutional investor and/or managerial stock ownership may provide effective agency control devices. 1




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deregulation, reregulation, equity ownership, and s&l risk-taking

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