How depository institutions can increase risk?

Recall that the flat premium charge provides incentives to depository institution to incur more risk. It is important to realize that as an institution becomes weak, it has even more incentives to take on more risk. For one thing, if the higher risk pays off, the institution can avoid the "troubled" list, which brings with it more regulation and constraints on management behavior. For another, if an institution is insolvent and waiting to be closed, or if it is nearly insolvent, managers have a strong temptation to take a final chance at a big score to avoid bankruptcy. By not closing insolvent institutions, therefore, deposit insurers induce risk taking. But how can depository institutions take on more risk?
Increasing leverage One major method of increasing risk is to increase the institution's leverage(debt), by reducing its ratio of capital to assets. one way in which to do that is to increase the size of the institution ans finance it by borrowing; another is to issue debt and issue the proceeds to stockholder as dividends, instead of purchasing additional assets. yet another is what economists call affiliated-institution risk. This occurs when a depository institution issues debt backed partly by the value of the capital of an affiliated institution, which commonly is a bank holding company. this effectively permits a depository institution to grow without expanding its own capital, but it simultaneously increases the risk incurred by the institution by linking its safety and soundness to the capital of a separate firm.
Changing the composition of assets or liabilities A further method by which a firm can incur additional risk (without affecting the leverage of its portfolio) is by increasing its total portfolio risk. this can be done by changing the composition of the institution‘s assets or the composition of its liabilities used to finance the assets. commercial banks in fact have changed the composition of their assets by increasing the ration of their loans to securities . In effect,the percentage of these banks‘ portfolios invested in high-credit-risk assets (loans) has increased at the expense of low credit-risk assets. At the beginning of the 1980s, the share of commercial bank assets in cash and securities was roughly 36 percent of total assets. By the end of the decade, it amounted to just 27 percent. In contrast, the portion of total assets allocated to loans grew from 54 percent to 61 percent.
portfolio risk can also be raised by increasing the amount of credit risk in a bank ‘s high-credit-risk assets: bank managers can replace less risky loans with riskier ones. Regulators, in fact, have complained that in recent years the asset quality of many thrifts and banks has declined considerably. Of particular concern has been the growth in real estate lending at the expense of commercial and industrial(C&I) loans.C&I loans made by commercial banks- the traditional bread and butter business of the industry- declined during the 1980s and 1990s, while real estate loans grew considerably in relative importance.
Decreasing portfolio Diversification bank mangers can also increase portfolio risk by decreasing the portfolio ‘s degree of diversification. it is believed that the 1984 failure of Continental Illinois Bank was partly due to that institution‘s excessive reliance on high interest borrowing as a source of funds (instead of lower-cost deposit); in effect it increased overall risk by increasing risk on the liability side of its balance sheet. Finally, total portfolio risk can be increased by mismatching asset maturity and liability maturity- or mismatching interest rate sensitivity of assets and liabilities. In today ‘s environment, deposit-receiving institutions have incentives to increase their leverage, portfolio risk, or both, because such activities are subsidized by deposit insurers: the FDIC, the federal government, and-ultimately-taxpayers. such subsidization, however:
1. gives insured institutions a competitive advantage over uninsured institutions;
2. induces higher degrees of risk taking than would be the case if there were no subsidies.
Note that if deposit insurance were priced "properly' (i.e., to reflect the institution‘s individual risk), then factors 1 and 2 would not exist.