Reputation in Banking and Deposit Insurance:
The Dynamics of Borrowing and Lending under Regulation
Fernando Gascon Garcia-Ochoa
Department of Business Administration and Accounting
University of Oviedo (Spain)
E-mail: fgascon @hp845.econo.uniovi.es
Abstract
Debt contracts are cost-efficient rules designed to control opportunistic behaviour on the part
of managers, who are assumed to have better information than lenders. Although contracts
are imperfect, in practice managers voluntarily forbear from many kinds of opportunistic
actions. They do so because the reputation for forbearance is valuable to them and their firms.
A concern for reputation would help to align the interests of lenders and stockholders. Game
theoretic approaches have been applied to explain formally how reputation is created and
maintained in a multiperiod scenario under very restrictive initial assumptions. An S.D.
approach is considered studying the dynamics and feedback effects of the borrower-lender
relationship, modelling the behaviour of “Banco Herrero”, a Spanish local bank when dealing
with its customers and the regulator.
Introduction
We consider two borrower-lender relationships: depositors-bank relationship and bank-loan
demanders relationship and we try to identify and model the differences in the amount of
information required for both types of lenders (depositors in the first relationship and bank in
the second relationship) to trade with borrowers. We argue that reputation and deposit
insurance are both substitutes of information and monitoring when trying to avoid the effects
of opportunistic behaviour.
The asymmetry of information between borrowers and lenders contributes to the existence of
agents that specialize to profit from scale economies when examining and evaluating
borrowers. It is too costly to analyze at the individual investor level the creditworthiness of all
the investment opportunities that exist in the market and monitor those opportunities. Then,
multiple investors will find it more profitable to deposit their funds at the bank against the
promise to make certain payments and the bank will give this money in the form of loans.
It also may be that multiple investors give money to a single agent because no investor is rich
enough to finance a given project (loan) alone, or because no investor wishes to bear the risk
of financing the project alone (investors are risk-averse) or to harden the entrepreneur’s
budget constrain. Whatever might be the case, disperse shareholders/creditors have little or
no incentive to monitor management. The reason is that monitoring is a public good: if one
shareholder’s (debtholder’s) monitoring leads to improved company performance, all
shareholders (debtholder’s) benefit. Given that monitoring is costly, each shareholder
(debtholder) will free-ride in the hope that other shareholders (debtholder) will do the
monitoring. Unfortunately, all shareholders (debtholder) think the same way and the net result
is that no - or almost no- monitoring takes place. See Hart (1995: 127)
1b
Therefore, as lenders may ignore the credit quality of final borrowers they may ignore the
credit quality of banks. So as well as the bank should control borrowers’ opportunistic
behavior, depositors should control the opportuiistic behavior of the agent(bank), however,
they seem to fail. This fact may not be important if the amount of information that a depositor
needs to trade with a bank is minimal, compare to the amount of information a bank needs to
trade with a borrower. We try to identify and model why are these differences in the amount
of information required and why reputation is important in the bank-borrower case and not
important in the depositor-bank case.
The model
The model studies informational actions devised by lenders when allocating funds. It is run
with two sets of parameters: for the depositor-bank relationship and for the bank-borrower
relationship.
We assume that depositors have to place their funds in one or various banks (so they have to
choose among banks and then decide to what extend they will monitor bank creditworthiness)
and banks have to invest the money in the form of loans (so they have to choose among
borrowers and also monitor them). Then, the decision is whether and how much information
to collect, that is to say, a decision concerning whether and how to improve one’s state of
knowledge before coming to a terminal decision which is in this case the allocation of funds.
[See Hirsheifer & Riley (1992) for a more detailed description of informational and terminal
decisions].
In the model, information (See figure 1) is considered both as a) knowledge and experience
(know-how) and as b) An accumulated body of timely data or evidence about the world
(Stock of up-to-date news). Information as know-how increases through repeated trading
(experience) and through the implementation of technology. The limits to the growth of
know-how depend on the state-of-the-art of technology and on a certain critical level of
experience which, when approached, progressively reduces the benefits gained from
additional experience. Know-how is out-of-date through innovation so it does not depend so
much on time but on sporadic events with no “timetable”.
Information as a stock of up-to-date-news depends on pieces of information that get quickly
up-to-date and are more volatile. Also since you can never know in advance what you will be
learning from the news, you can never purchase a message but only a message service which
implies that some of the gathered information is useless, repeated or difficult to interpret.
Being informed is costly and it is only worthwhile if it is possible to obtain an extra return on
this information. Information can be obtained through experience, direct market purchase, by
observing the market choices of better-informed traders or drawing inferences from people’s
reputation acquired in the course of their previous market dealings. Know-how is lengthy to
obtain and easy to maintain while up-date news are quickly obtained although quickly get out-
of-date. If revenue from the loan investment is as expected (debt is fully recovered), then
there is no need to increase the resources dedicated to obtain more information and
information costs tend to be reduced if debt is once and again recovered.
(et
aoe of eee uli of-date
News B ”
gathered orrower's
reputation
rity of a good
Probability of evaluating an investment outcome
monitoring correctly borrowers
creditworthiness and
investment opportunities
Probability of
Allocated recoverin Probability of
Resources ig
money from debt repayment
collaterals
i Pronto —— Oe Out-of-date
New acquired_——{*)} > okies
knowledge pe
and Sp
experience
a Innovation
Expenses
-)b
Revenue from loan
foyestment Third-party collateral
(a with no risk involved
(only for banks)
Necesity to
acquire news and Discrepancy
knowledge oniravenue Expected revenue from
investment (interests on loan plus
return of principal)
Figure | - Information and other means of increasing the probability of debt repayment
If the cost of being informed is too high then alternatives must be devised if trade is to take
place, a high probability of debt repayment is ensured through different substitutive channels.
This objective may be warranted if the probability of the investment outcome is high even if
there are no collaterals and reputation is non existent or unknown. Altematively the
probability of a poor investment outcome may be high or unknown but collaterals or
reputation may suffice to have a high probability of debt repayment. The advantage of
collaterals is that there is little need for information once it is proved to be a valid collateral,
[ub
so collaterals are a substitute for information and so is reputation (it is only necessary to
know if all the previous debt payments have been honoured).
Preliminary results
For final borrowers, reputation would be important because they would find it profitable to
forbear from opportunistic behaviours if in the long-term debt costs are reduced through
lower interest rates in future loans. Banks when dealing with multiple final borrowers are
reducing risk, since the risks associated with different assets are generally partially offsetting,
diversification reduces the chance of ending up with an extremely poor results. Diversification
implies a search for alternative trading partners however risk reduction can take place with a
reduced information about partners creditworthiness.
In regulated markets depositors should not care about bank creditworthiness, they are
protected through deposit insurance and if they are protected enough, which is normally the
case, they have no incentives to obtain extra information. It would not be worthwhile to
obtain and process information which implies only new costs, nor even diversification would
be worthwhile.
Spanish bank “Banco Herrero” did not profit from the existence of deposit insurance
coverage. The bank followed conservative loan policies which lead to reducing the local loan
portfolio and increasing the interbank loan portfolio (leaving the job of allocating funds to
final borrowers to other banks).
References
Diamond, D. W.: "Reputation Acquisition in Debt Markets". Journal of Political Economy,
97, pp. 828-862.(1989) in Frontiers of Finance. The Batterymarch Fellowship Papers.
Miller, D. H. y Myers, S. C. eds., Basil Blackwell (1990).
Hart, O.: Firms, Contracts and Financial Structure. Oxford University Press. (1995)
Hirsheifer J. & Riley J. G.: The Analytics of Uncertainty and information. Cambridge
University Press (1992).
John K, & Nachman D.C. : “Risky Debt, Investment Incentives, and Reputation in a
Sequential Equilibrium” Journal of Finance 40, pp 863-78 (1985).
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