The role of relative performance in bank closure decisions

This paper studies a competitive banking industry subject to common and idiosyncratic shocks. The induced correlation across bank portfolio returns can be used by a regulator to improve inferences about bank portfolio choices. We compare two types of closure rules: (1) an 'absolute closure rule', which closes banks when their own individual asset/liability ratios fall below a given threshold, and (2) a 'relative closure rule', which closes banks when their asset/liability ratios fall below the industry average by a given amount. ; Two main results emerge from the model. First, a relative closure rule implies forbearance during 'bad times', defined as adverse realizations of the common shock. This forbearance occurs for incentive reasons, not because of irreversibilities or political economy considerations. Second, a relative closure rule is less costly to taxpayers, and the cost savings increase with the relative variance of the common shock. ; To evaluate the model, we estimate a panel-logit regression using a sample of U.S. commercial banks for the period 1992 through 1997. We find strong evidence that U.S. bank closures are based on relative performance. Individual and average asset/liability ratios are both significant predictors of bank closure, and their coefficient estimates are consistent with the theory. We conclude that relative performance is a valuable input to bank closure decisions, and that U.S. bank regulators seem to be aware of this.