Firm Size and Moral Hazard: Evidence from Banking Industry

Abstract

From the panel regression analysis, we compared the relationships among bank asset size, risk-taking and performance for the two different regulatory regimes in Korean banking industry; 1994∼1997, the period of deregulation, vs 2000∼2005, the period of tightened regulation. We found that larger banks took riskier strategies than smaller banks for the pre∼1997 period of very loose regulation. But their strategies were significantly more profitable than smaller banks. Thus, we conclude that severe moral hazard problem associated with firm size did not exist in Korean banking industry, and therefore, this may not have been one of the main reasons for the financial crisis during the period of at least 1994∼1997. After the regulation got tightened since 1998, we found that the tendency of the larger banks to take profitable risk-taking strategies became weaker. That is, the risk-taking incentives of larger banks became weaker, and moreover, the positive association between risk-taking and profitability became weaker after regulatory reforms. These results may be attributed to the fact that the acquisition of unhealthy, riskier and smaller banks by larger banks was the main method of reorganizing and resolving the financial crisis for the period of post∼1998 in Korean banking industry, and this may have aggravated the profitability of the larger banks.