Explicit deposit insurance and bank risk-taking: Does banking supervision matter?

Mumtaz, Raheel; Jadoon, Imran Abbas; Sohail, Nadeem Article Explicit deposit insurance and bank risk-taking: Does banking supervision matter? Pakistan Journal of Commerce and Social Sciences (PJCSS) Provided in Cooperation with: Johar Education Society, Pakistan (JESPK) Suggested Citation: Mumtaz, Raheel; Jadoon, Imran Abbas; Sohail, Nadeem (2019) : Explicit deposit insurance and bank risk-taking: Does banking supervision matter?, Pakistan Journal of Commerce and Social Sciences (PJCSS), ISSN 2309-8619, Johar Education Society, Pakistan (JESPK), Lahore, Vol. 13, Iss. 3, pp. 727-748 This Version is available at: https://hdl.handle.net/10419/205275 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Raheel Mumtaz (Corresponding author) College of Commerce, Government College University, Faisalabad, Pakistan Email: raheel[email protected]du.pk Imran Abbas Jadoon Department of Management Sciences, COMSATS University Islamabad, Pakistan Email: [email protected] Nadeem Sohail College of Commerce, Government College University, Faisalabad, Pakistan Email: sohail524[email protected]m Abstract This study explores the influence of supervisory powers and structure of a banking supervisor on the bank’s risk-taking caused by the implementation of explicit deposit insurance (EDI). We explore the data of publically traded 1,936 banks of 96 countries, from the Bank scope during 2002 to 2015. Using the Hierarchical Linear Modeling (HLM), findings revealed that banking supervision reduces the moral hazard of bank’s risk-taking in non-crisis affected countries, either allocated supervisory powers are low or high. Additionally, conferring the greater supervisory authority to banking supervisor strengthened the financial health of banks amongst both crisis and non-crisis affected countries. Furthermore, central bank working as a banking supervisor with greater supervisory powers seemed to mitigate the moral hazard of bank’s risk-taking. While central bank’s low supervisory powers have little or no impact to controlling the bank risk-taking. Hence, the allocation of greater supervisory powers to a central bank heightens the investors and depositors’ confidence in the depository financial institutions. Keywords: official supervisory powers, supervision structure, deposit insurance, bank risk-taking, moral hazard. 1. Introduction The espousal of EDI reduces the possibility of bank-run which improves the social welfare and decreases the adverse shocks of financial crisis in the banks (Anginer & Demirguc-kunt, 2018; Boyle et al., 2015). Hence, the adoption of EDI offers guarantee to depositors for safety-nets of deposits and it uplifts the depositor’s confidence in banking system (Calomiris & Jaremski, 2016; Prean & Stix, 2011). Conversely, the assurance of deposit insurer diminishes the incentives for creditors to observe bank’s activities (Yan, Skully, Avram, & Vu, 2014). Thus, the absence of depositors’ monito ring reduce the market discipline on bank’s risk-taking (Anginer & Demirguc-kunt, 2018). Consequently, Explicit Deposit Insurance and Bank Risk-Taking 728 the implementation of EDI upsurges the moral hazard of bank’s risk-taking (Kusairi et al., 2018; Liu et al., 2016), because the cost of bank failure bear by a deposit insurer (Forssbaeck, 2011; Storbacka, 2018). Moreover, the bank’s risk-taking arises from the implementation of EDI outweighs the positive effect of EDI on the prevention of bank run (Ngalawa et al., 2019). Based on the discussion, the adoption of EDI lessens the possibility of bank-run (Grira et al., 2016), but it increases the moral hazard of bank’s risk-taking which heightens the likelihood of financial crisis (Liu et al., 2016). This moral hazard of bank’s risk-taking can be reduced by appropriate vigilant supervision of the banking supervisor (Chortareas et al., 2012). Therefore, the banking legislators design the supervision that strengthens the banks’ financial soundness and promote the smooth economic development (Beck et al., 2006). Whereas, the deposit insurer depends on the banking regulator for supervision of bank’s activities, to monitor and control the moral hazard of bank’s risk-taking (Kahn & Santos, 2005). Banking supervision consists on the allocated supervisory powers and organizational structure of banking supervisor (Herring & Carmassi, 2008). The EDI upsurges the moral hazard of bank’s excessive risk-taking (Anginer & Demirguc-kunt, 2018). Therefore, bank’s risk-taking behavior increases the likelihood of banking crisis that leads toward a decline in economic growth of a country. This adverse effect of EDI motivates the researchers; there should be some policy measures which may implement by the legislators to decrease the bank’s risk taking. The global financial crisis of 2007-09 highlighted the adverse effect of EDI on bank’s risk-taking which needs to be addressed appropriately on timely manners to retain the depositor’s confidence on financial system (Anginer et al., 2014b). There is limited body of literature which investigates that either to confer low or high supervisory authority to a banking supervisor in order to reduce the bank’s risk-taking engendered by EDI. Whereas, there are numerous countries which allocate the low and alternatively greater supervisory powers to a banking supervisor. Additionally, either to allocate the supervisory function to a central bank Masciandaro & Quintyn (2009) or outside of a central bank i-e Financial Supervisory Authority (FSA) which may likely to decrease the moral hazard of bank’s risk-taking? The objectives of this study are to examine which specific allocated supervisory powers and structure of a banking supervisor may declines the moral hazard of bank’s risktaking. We validate the economic theory by examining the influence of supervisory authority and structure of banking supervisor in the theoretical paradigm of EDI. It empirically recommends that the allocation of greater supervisory powers to a banking supervisor in a country and vesting the supervisory function to a central bank decreases the bank’s risk-taking. Accordingly, the banking policymakers may devise surveillance policies in compliance with the findings of this study to enhance the soundness of banking sector. Resultantly, it will improve the investors and depositors’ confidence in the depository financial institutions around the globe. 2. Literature Review In economic theory, moral hazard is a state in which an agent (bank) taking the risk and principal (deposit insurer) pays the cost of this risk (Arrow, 1971). These parties are bound by a contractual arrangement between the state and the governed (Ross, 1973). Mumtaz et al. 729 Therefore, the behavior of a bank may change after the transaction taken place to the detriment of other, because the bank has more information about its intentions than a deposit insurer. Hence, the bank may has the incentives to act according to its plans if deposit insurer does not monitor the bank’s actions appropriately. Whereas, deposit insurer cannot completely monitor the behavior of banks. For the reason, deposit insurer relies on another agent (e-g central bank) to monitor the bank’s activities and take corrective action to limit the negative effect of the outcomes (Miles, 2012). According to economic theory, the allocation of appropriate supervisory powers and organizational structure to a banking supervisor can minimize the bank risk-taking on behalf of deposit insurer. The adoption of EDI increases the moral hazard of bank’s risk-taking (Kusairi et al., 2018) in the absence of appropriate supervision (Merton, 1977). Subsequently, literature argue that the adoption of EDI reduces the bank invested capital which increases the bank’s risk-level if there is no monitoring. This banking risk transfers to the government through deposit insurer fund (Diamond & Dybvig, 1986). Ronn & Verma, (1986) shows that strict supervision of banks might limit the bank’s risk-taking. Consistent with this view, Gennotte & Pyle (1991) describes that the implementation of EDI leads to inefficient investment by banks while the higher capital requirement is not the substitute for the banks risk monitoring and control. Hence, there should be strong supervisory framework developed to cater the bank's risk-taking. In the light of economic theory, Demirgüç-Kunt & Kane (2001) recommended that the adoption of EDI reduces the negative effect of financial crisis, but it is necessary to establish a strong supervisory framework in a country, in conjunction with the inception of deposit insurance. Banking supervisor has a responsibility to ensures the financial stability of the banks by analyzing their risk and subsequently compelling the corrective action for mitigation of the risk-taking (Herring & Carmassi, 2008). There are limited studies which analyzed the effect of appropriate banking supervision on the bank risk-taking provoked by EDI. The EDI increases the bank’s risk-taking, while there are arguments which suggest that appropriate supervision can decline the of bank’s risk-taking. The role of supervision for mitigation of bank's risk-taking depends on the allocated powers to a banking supervisor (Shehzad & Haan, 2015) and organizational structure of banking supervisor (Herring & Carmassi, 2008; Masciandaro & Quintyn, 2009). 2.1 Official Supervisory Power Official supervisory powers include how much powers are vested to the banking supervisor to take wide array of actions to prevent problems, discipline banks, correct the problem perceived, including authority to meet, demand bank information, and punish external auditors of the banks, force banks to disclose information to the banking supervisor, order the directors of the banks to change its organizational structure, constituency of loan provisioning, suspend decision to pay fees, bonuses and dividend, and declare a bank insolvent or intervene in a problematic bank (Barth et al., 2006). Proponents for the allocation of greater supervisory powers to a banking supervisor argue that extensive control may decrease the bank’s risk-taking espoused by EDI. For the reason that banking supervisor have more authority to influence management, directors, Explicit Deposit Insurance and Bank Risk-Taking 730 auditors, and shareholders of the banks (Barth et al., 2004). So, it suggests that to allocate the greater powers to a banking supervisor. Hence, forty-three countries increased the vested supervisory powers of the banking supervisor (Barth et al., 2013). On the other hand, the critics for the allocation of greater powers to a banking supervisor highlight the various situations where banking supervisor used their authorities to extract a bribe, attract companion donation to benefit their favored constituents (Barth et al., 2004). In these cases, the greater supervisory powers might be related to in-efficiency of banks, promote corruption, decrease development, stability, and performance of the banking sector. Therefore, sixty-one countries reduced the conferred official supervisory powers of banking supervisor after the financial crisis of 2007-09 (Barth et al., 2013). There is wide spread arguments in literature that the allocation of greater supervisory powers to a banking supervisor affect the bank risk via two ways, moral hazard and stabilization. While, allocated supervisory powers of banking supervisor varies among EDI adopted countries (Barth et al., 2013) but there are limited studies which determines that whether to confer the lower/higher supervisory powers to a banking supervisor which likely to reduce the bank’s risk-taking. Empirical studies of official supervisory powers examine that reinforcement of official supervision is positively linked with banks’ efficiency where financial supervisor worked independently (Barth et al., 2013), and increases the banks’ soundness (Doumpos et al., 2015). Economic theory supports the view, the deposit insurer hires the banking supervisor (central bank of financial supervisory authority) to oversee the bank’s activities and took corrective action to align the bank’s actions according to the deposit insurer goals. Above discussion on the topic may deduce the following hypothesis:  H1: EDI upsurges the bank’s risk-taking while it is reduced by the allocation of greater supervisory powers to a banking supervisor. 2.2 Supervisory Structure (Central Bank Involvement in Financial Supervision) Supervision structure is based on characteristics, how the banking supervisory architecture designed in a country. Either central bank of a country performs the supervisory function, or these powers are conferred to the banking supervisor outside of a central bank (Doumpos et al., 2015). Although, central bank participation in banking supervision has its advantages and disadvantages for an alternative arrangement. There are rational arguments which support allocation of the supervisory function to a central bank. It includes the economies of scale, access to timely and accurate information, the capacity of a independent central bank to enforce actions, the comparative advantage of a central bank to recruit and retain the best staff (Barth et al., 2004; Barth et al., 2002; Barth et al., 2013; Beck & Gros, 2012; Masciandaro & Quintyn, 2009). Based on the arguments above, it concludes that central bank can monitor bank’s activities accurately and on timely basis and it has an advantage over other supervisory institutes to take a wide array of action against any discrepancy prevailing in the banking system. Conversely, there are arguments which opposes to assign the supervisory responsibility to a central bank includes the moral hazard risk, scope diseconomies, increase of bureaucratic powers and loss of independence (Barth et al., 2002; Barth et al., 2003; Beck & Gros, 2012; Masciandaro et al., 2013; Masciandaro & Quintyn, 2009). Additionally, Mumtaz et al. 731 central bank performs as the bank’s supervisor can relax the financial policies to avoid the possible adverse effect of policies on the bank’s solvency and profitability (Goodhart & Schoenmaker, 1995). Thus, the bank’s management perceives that central bank supports the banks to avoid insolvency if liquidity problem arises under its’ supervision (Klomp & de Haan, 2009). Consequently, the policymakers prevent the allocation of supervisory function within the central bank because it creates the excessive risk-taking (Barth et al., 2002). Therefore, thirty-nine countries vested the banks’ supervisory powers outside of the central bank (Masciandaro & Quintyn, 2009). This trend is more significant in high-income countries and less in the low-income countries (Melecky & Podpiera, 2013). In a review of the revolutionary regime of supervisory structure in 88 countries through 1998 to 2010, it is revealed that there is a trend to transfer the supervisory function outside of a central bank (Masciandaro & Quintyn, 2009). The implementation of EDI upsurges the bank’s risk-taking (Anginer & Demirguc-kunt, 2018). Simultaneously, the countries where central bank is performing the supervisory function, it have added effect on the bank’s risk-taking (Barth et al., 2002). Whereas, empirical studies scrutinize the effects of supervision structure on the banking crisis (Noy, 2004), banks’ soundness (Barth et al., 2002; Doumpos et al., 2015), performance (Barth et al., 2003), and examine its’ determinants (Melecky & Podpiera, 2013). Moreover, central bank oversight may reduce the liquidity risk & overhead cost of the banks and increased the non-performing loans (Barth et al., 2002). Furthermore, central bank working as lead supervisor raises the capital to asset ratio, non-performing loans to GDP ratio of the banks and decreases the banks’ profitability (Barth et al., 2002; Dincer & Eichengreen, 2012). Gaganis & Pasiouras (2013) find that financial efficiency of the banks declines as the number of financial sectors supervises by a central bank went up. Whereas, central bank participation in the financial sector supervision increased the bank soundness during the crisis period in a country (Doumpos et al., 2015). There is no consensus to separate the function of monetary policy and bank supervision from central bank (Beck & Gros, 2012). However, policymakers likely to face a trade-off between cost and benefit for the participation of central bank in banking supervision. Whereas, supervision structure of banking sector varies among EDI adopted countries (Barth et al., 2013). As this area of research received little attention from the researchers, hence above discussion on the topic may comprehend the following hypothesis:  H2: EDI upsurges the bank’s risk-taking while this influence is reduced where central bank is working as a banking supervision. 3. Data and Empirical Methodology 3.1 Data and Sample We perform the analysis on secondary data of 1,936 listed deposit-taking banks from 96 countries (including fifteen countries affected by the financial crunch of 2007-09). We employ the annual data for the period of 2002-2015 covered by the Bank scope database which covers about 90% data of all banks in the world. The sample is selected on the following criteria: 1) the bank has more than $400 million as total asset to exclude the regional banks (Storbacka, 2018), 2) the World Bank published the data of official Explicit Deposit Insurance and Bank Risk-Taking 732 supervisory powers in their survey conducted over time, and 4) World Bank released the cross-country variables data in the GFDD. Bank level financial variables data are abstracted from Bank scope database. Crosscountry variables data are obtained from the two sources. First, the crisis affected country data is collected from Laeven & Valencia, (2013) database, which accounts for the banking crisis affected countries. It reports the period when a nation experience the banking crisis (Leaven & Valencia, 2013). For the reason that global financial crisis (2007-09) adversely affect the profitability of banks in crisis-affected countries and decreased the strength of banking system. Second, The data of country-level variables are composed from the World Bank’s GFDD. The data of EDI variables are collected from IADI database. Whereas, the official supervisory power data is collected from the surveys conducted by the World Bank’s over time. 3.2 Variables Measurement 3.2.1 Explicit deposit insurance EDI is measured by dummy variable which adopts the value one if a nation established the deposit insurance corporation and creditors were adequately rewarded in the past event of bank failure (Anginer & Demirguc-kunt, 2018). 3.2.2 Official Supervisory Power Barth et al., (2004) developed the official supervisory powers index that shows the extent by which supervisory institute has the power to restraint banks by performing specific activities to avoid and correct the problems. This index is based on individual questions of the World Bank’s survey, which was conducted by the researchers from 1999 to 2012. Index takes the value from 0 to 14, where higher score denotes the higher supervisory powers of the banking supervisor. Official supervisory power index widely uses in the literature as a measure of bank’s corrective decision ( Doumpos et al., 2015; Gaganis & Pasiouras, 2013; Shehzad & Haan, 2015). So, we used the official supervisory powers index to measure the supervisory authority of a banking supervisor. 3.2.3 Supervision Structure Supervision structure dummy is based on the index of central bank’s involvement in the banking supervision, developed by the Masciandaro, (2007). We use this index to develop the dummy variable which take the value of one if central bank involved in the banking supervision and zero otherwise. Central bank participation in financial supervision index is widely used to examine the supervisory architecture of a central bank in the country (Doumpos et al., 2015). 3.2.4 Bank Risk Z-score is used to measure the bank risk, which is equal to the sum of Return On Assets(ROA) and the capital to asset ratio divided by the three year rolling window standard deviation of ROA (Laeven & Levine, 2009). The z-score values are highly skewed, so we take the natural log of z-score. The greater value shows the strength of a bank while lower value demonstrates that the bank indulges in risk-taking activities (Anginer & Demirguc-kunt, 2018; Ngalawa et al., 2019). Mumtaz et al. 733 3.2.5 Bank-level Control Variables We employ the financial variables to control the possible effect of bank level characteristics on the bank risk. It includes the bank size, leverage, reliance on deposits for funding and liquid assets. Bank size is calculated by the natural log of total assets (Anginer & Demirguc-kunt, 2018; Kusairi et al., 2018; Ngalawa et al., 2019). Leverage measures as the liabilities of a bank divided by total assets (Guizani & Watanabe, 2016). Deposits measure as the total deposits in percentage of total assets. Liquid assets measure by liquid assets of a bank divided by total assets (Davis & Obasi, 2009; Forssbaeck, 2011). 3.2.6 Country-Level Control Variables We include the control variables at country level that control the potential omitted variable problem to measure the true affect of banking supervision on the bank risk. Dummy variable is employed to control the impact of global crisis of 2007-09 which adopt the value of one when a country experience the banking crisis and zero otherwise (Storbacka, 2018). For the reason that global financial crisis (2007-09) adversely affect the profitability and decreased the stability of banking industry in the crisis-affected countries. Financial development of an economy is calculated as the Ln of GDP per capita (Anginer & Demirguc-kunt, 2018), as healthy economies improve the strength of banking sector (Barth et al., 2013). Ln(population) is employed to calculate the country size (Pellegrina, Masciandaro, & Pansini, 2013) because it influence the decisions of policy-makers in the banking sector (Masciandaro & Quintyn, 2009). We concentrate on the banking sector development and structural control variables to incorporate the potential error of omitting variables. Stock market cap. to GDP is employed for the financial development of a country (Masciandaro, 2007). Central bank assets to GDP is used to measure central bank’s powers to implement policies in the banks. The higher ratio indicates, the more fabulous resource of the central bank to supervise banks and conduct strategies (Doumpos et al., 2015). Furthermore, concentration of banking sector measures by the total assets of three large banks in percentage of total assets of all banks. For the reason that greater banking concentration negatively influence the banks efficiency (Barth et al., 2013). 3.3 Methodology We used the multilevel dataset where banks data are nested in a country over the number of years. Therefore, HLM is better than ordinary least square (OLS) regression because it considers that data based on different ranks of aggregation (two cross-sections i-e bank and country level). Furthermore, it presents the error terms that account for the dependency effect of the nested data while it is not in the case of OLS output. Specifically, by applying HLM regression on the banks and country level simultaneously, it considers that banks in the same country are more similar as compared to the banks of another country. Additionally, HLM permits the division of the deviation in the bank risk explicated by the time, bank and country level features. Accordingly, HLM is employed for estimation of research models and this technique is widely used in the cross-country studies (Doumpos et al., 2015; Kayo & Kimura, 2011). Explicit Deposit Insurance and Bank Risk-Taking 734 The model is estimated by employing the iterative maximum likelihood algorithm, where the random and fix effects are estimated concurrently till the model converges. It can be written in compact form as follows: Where BRTi,j,t is the bank risk for i bank, in j country, in tth year, Xi,j,t-1 is the combination of lagged bank-level variables, and Wj,t-1 is the combination of lagged country-level variables. The random parts of the model (µi,j & еj) permits the intercept (country-specific effect + bank-specific effect + intercept) to be random and have distinctive values for all banks and countries. Hence, research models assume that intercept value can deviate but slope values are fixed. Moreover, we winsorize the financial variables at 1st and 99th percentile level of distribution to eliminate the potential effect of the outlier and remove the likelihood of data error. Moreover, we use the lagged financial variables by a year to remove the reverse causality problem (Iyer, Puri, & Ryan, 2016). 3.4 Research Models We extend the research model of Anginer et al., (2014) by adding the effect of lower/high supervisory powers of a banking supervisor on the bank’s risk-taking. This section splits data into two parts on the basis of the median value of official supervisory powers, where below median values consider that banking supervisor have low authority and above median values show that banking supervisor have greater powers to align banks with the banking regulations. Furthermore, the banking crisis vibrated the effect of supervisors’ official supervisory powers on the moral hazard of banks’ risk-taking and adversely influenced the soundness of banking system (Doumpos et al., 2015; Laeven & Valencia, 2013). So, the dummy variable is generated which represents the non-crisis affected countries, to differentiate between the crises vs. non-crisis affected countries. Henceforth, we analyze the influence of (lower vs. greater) official supervisory powers on the bank risk in crisis and non-crisis affected countries separately. tj,i,ji,o,jo,o,1tj,i,j4,1tj,i,j3, 1tj,i,j2,1tj,i,j1, jo,o,o,6o, jo,o,o,5o,jo,o,o,4o, jo,o,o,3o,jo,o, o,2o, jo,o,o,1o,tj,i,ji,1,oo,o,tj,i, μμe+)(Liquidityβ)(Depositsβ )(Leverageβ)(Sizeβ )tion/GDPcapitalizamarket (Stock γ+ )ation)(Log(Populγ+)ionconcentrat (Bankingγ+ )country oft developmen (Economicγ)countries affected crisis-crisis/nonin powersy supervisor (Officialγ )dummy insurance(Deposit γ)(YearΩαBRT        (3a) .T1,2,3..... t .N,1,2,3.....j .N,1,2,3.....i Where  tj,i,BRT = is the bank’s risk-taking, which measured by the z-score, BRTijt = α + βXijt-1 + γWjt-1 + µij + еj + µijt Fixed Random Mumtaz et al. 741 (0.026) (0.070) (0.070) (0.036) (0.036) Residual variance 1.996*** 1.831*** 1.830*** 1.823*** 1.823*** (0.026) (0.041) (0.041) (0.031) (0.031) Model-fit Statistics AIC 51113.4 17811.2 17809.2 29134.0 29134.5 BIC 51063.4 17761.2 17759.2 29084.0 29084.5 Countries 96 83 83 47 47 Banks 1936 895 895 1262 1262 Yearly Observations 13941 4847 4847 8112 8112 Dependent Variable: Ln (z-score) Table 3 presents the estimates of hierarchical research model by employing the maximum likelihood method. Sample consists on the data of 1,936 banks from 96 countries during 2002- 2015. The values in the parenthesis reports the standard errors underneath their coefficients. *, **, *** shows the significant level at 10, 5 and 1% respectively Based on the model (3) and (5) of Table 3, official supervisory powers decrease the risktaking of banks in EDI adopted countries which are not affected by the banking crisis, either vested supervisory powers are low or high. It might be the reason that the allocation of greater supervisory authority to banking supervisor not misused by the banking supervisor and it played the role as vigilant banking supervisors (Barth et al., 2006). Furthermore, it revealed that allocation of lower supervisory powers to banking supervisor reduced the bank’s soundness, while greater supervisory powers boost the soundness of banks in a country. It may be the reason that countries where banking supervisory powers are low, banks take excessive risk in those countries to enrich the bank’s return. Alongside, it is supposed that banking supervisor has fewer powers to take action which prevent banks from risk-taking (Barth et al., 2004). Conversely, in the model (2) and (4), bank’s risk-taking activities went up in the crisisaffected countries, either vested supervisory powers of banking supervisor is low or high. It indicates that official supervisory powers of the banking supervisor enhances the bank’s risk-taking in the banking crisis-affected countries. It may be the reason that financial supervisors indulge in to extract bribe and companion donation to their favored constituents which increases the negative effect of EDI (Barth et al., 2006). It may be the reason that financial crisis reduces the bank's profit and their capital to asset level, so this leads to the increase of bank risk (Laeven & Valencia, 2013). 4.4 Deposit Insurance and Bank Risk-Taking: In Cross-Section of Structure of Banking Supervisor Model (1) through (4) of Table 4, reports the role of central bank’s supervision on the bank’s risk-taking initiated by the implementation of EDI. We divide the data into two groups based on the official supervisory powers, where below median values are considered as low supervisory powers are vested to a banking supervisor, reported in the model (1) and (2). Whereas, above or equal to the median value is considered as greater Explicit Deposit Insurance and Bank Risk-Taking 742 supervisory authority is vested to the central bank, as reported in column (3) and (4). The VIF values ranges from 1.30 to 2.51 for the model (1) through (4). Model (1) of Table 4, reveals that the implementation of EDI upsurges the bank’s risktaking. Moreover, the allocation of low supervisory powers to central bank magnify the bank risk among crisis-affected country, but it is significant at the level of 10 percent. Likewise, model (2) reports that low supervisory authority of central bank decreases the bank’s risk-taking in non-crisis affected countries, but this effect is significant at the level of 10 percent. It might be the reason that central bank’s supervision has limited powers to limit the banks from indulging into excessive risk-taking. Model (3) of Table 4 presents that allocation of greater supervisory powers to central bank enlarges the moral hazard of bank’s risk-taking among crisis-affected countries. It might be the reason that central bank with greater supervisory powers indulges in extract bribe, companion donations to benefit their favored constituents during economic down turn, consequently this will increase the negative effect of EDI. However, model (4) shows that EDI increases the moral hazard of bank’s risk-taking while a central bank with greater supervision powers increases the bank’s soundness in those countries which are not affected by the banking crisis. It may be the reason that central bank’s supervisors have better control over bank because of their access to accurate information and influence on the bank’s management. Mumtaz et al. 743 Table 4: Deposit Insurance and Bank Risk-Taking: In Cross-Section of Supervisory Structure Low Supervisory Quality High Supervisory Quality Fixed-effects parameters (1) (2) (3) (4) Constant 1.513 0.923 7.252 8.588 (1.226) (1.110) (1.171) (1.138) Year Fixed Effects Yes Yes Yes Yes Deposit Insurance Dummy -0.365** -0.340** -0.456*** -0.413** (0.153) (0.143) (0.158) (0.161) Central Bank’s Supervision in Banking Crisis Affected Country -0.024* -0.044*** (0.015) (0.007) Central Bank’s Supervision in Non- Crisis Country 0.019* 0.027*** (0.010) (0.007) Economic Development of a Country 0.177*** 0.200*** -0.031 -0.059 (0.062) (0.062) (0.046) (0.047) Ln(Population) 0.067 0.080* -0.014 -0.087 (0.048) (0.043) (0.037) (0.036) Banking Concentration -0.001 -0.002 -0.010** -0.013 (0.003) (0.003) (0.004) (0.004) Ln(Size) 0.028 0.029 -0.027 -0.017 (0.021) (0.020) (0.019) (0.019) Leverage - 1.271*** -1.328*** -1.824*** -1.830*** (0.448) (0.440) (0.480) (0.482) Deposits 0.669*** 0.650*** 0.380* 0.364* (0.188) (0.184) (0.205) (0.206) Liquidity -0.407* -0.443* -1.045*** -1.031*** (0.234) (0.231) (0.248) (0.249) Variance Decomposition Analysis Country-level 0.139*** 0.126*** 0.129*** 0.133*** (0.056) (0.053) (0.051) (0.049) Bank-level 0.510*** 0.521*** 0.556*** 0.567*** (0.047) (0.047) (0.039) (0.040) Residual variance 1.757*** 1.729*** 1.857*** 1.859*** Explicit Deposit Insurance and Bank Risk-Taking 744 (0.042) (0.041) (0.032) (0.032) Model-fit Statistics AIC 14567.4 14871.7 28055.8 28076.7 BIC 14517.4 14872 28007.8 28028.7 Countries 66 69 38 38 Banks 749 770 1165 1165 Yearly Observations 4064 4164 7761 7761 Dependent Variable: Ln (z-score) Table 4 presents the estimates of hierarchical research model by employing the maximum likelihood method. Sample consists on the data of 1,165 banks from 66 countries during 2002- 2015. The values in the parenthesis reports the standard errors underneath their coefficients. *, **, *** shows the significant level at 10, 5 and 1% respectively 5. Conclusion In last two decades, a number of countries reform their banking supervision to strengthen the banks’ soundness. Therefore, few countries increase the vested supervisory powers of banking supervisor, and few countries reduce the conferred powers of banking supervisor. Moreover, few countries allocate the banking supervision to the central bank while few rely on the financial supervisory authority (outside of the central bank). We have investigated that supervisory powers and its structure play a vital role in decreasing the bank risk which is incited by the adoption of EDI. The allocation of greater supervisory powers to the banking supervisor decreases the bank’s risk-taking aggravated by EDI. Moreover, banks are economically sound where banking supervisor has greater supervisory authority. On the other hand, the allocation of lower supervisory powers to banking supervisor decreases the moral hazard of bank’s risk-taking in existence of EDI, but it condenses the overall financial strength of the banking system. The allocation of greater supervisory powers to a banking supervisor in order to reduce the risk-taking is supported by the economic theory (Miles, 2012). Additionally, the arguments for the allocation of greater supervisory powers enhance the bank soundness is reinforced by the existing literature (Doumpos et al., 2015). Central bank as banking supervisor reduces the bank’s risk-taking where vested supervisory powers are high, at the same time, increases the overall financial health of the banking sector in a country. Conversely, low supervisory powers of a central bank have little or no influence on the bank's risk-taking. Hence, the banks have low soundness where central bank has low supervisory powers. Resultantly, the allocation of greater supervisory powers to a central bank decreases the bank’s risk-taking motivated by EDI and increases the overall soundness of banking system. In align with the findings, the literature on the bank’s risk-taking favored to assign the supervisory function to a central bank of the country (instead of financial supervisory authority outside of the central bank) to reduce the risk in the banking system. 5.2 Limitations and Future Directions This study considers the listed deposit-taking banks of IMF member countries because listed banks financial figures are more reliable as compared to the data of unlisted banks. Mumtaz et al. 745 This data is collected from the Bankscope database which almost covers the 90 percent of banking data around the globe. 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