Financial stability and deregulation: The impact of deposit interest rate deregulation on bank riskiness

What was the impact of U.S. financial deregulation on the recent wave of U.S. bank failures? This dissertation explores the relationship between financial stability and institutional structure by empirically examining the connection between banks' risk-taking and institutional changes caused by deregulation.;A simple theoretical model of a bank's choice of portfolio riskiness describes a risk-neutral bank that earns an uncertain return on investments. The model first demonstrates the well-known moral hazard problem arising from fixed-rate deposit insurance. The model next establishes that an increase in deposit interest rates leads to an increase in the bank's choice of riskiness. Deposit interest-rate ceilings, then, serve as a constraint on bank riskiness.;The data set contains cross-sectional and time series observations collected on individual banks in Louisiana for the period 1974-89. Three empirical measures of bank portfolio risk are derived: pseudo-beta, a new measure based on the beta from the capital asset pricing model; pseudo-variance, obtained similarly to pseudo-beta; and the discrete outcome for each bank, survival or failure.;The empirical model tests the impact of interest-rate deregulation on bank riskiness. The evidence indicates that deregulation altered the statistical and economic importance of the influence of deposit interest rates on bank risk choices. The coefficient describing the relationship between interest rates and risk is significantly positive in the post-deregulation period for each risk measure employed. A fixed-effects empirical model and a simultaneous-equations model offer additional evidence that the relationship is positive after deregulation. Estimated coefficients of a recursive model of bank failures imply that interest-rate deregulation had an economically important impact on the probability of bank failure; the state of the local economy was not the only factor involved in the failures. The empirical results suggest that deposit interest rates should be considered in policies designed to control banks' risk-taking.