PHD Thesis Lene Gilje Justesen

2015-15
Lene Gilje Justesen

PhD Thesis
Empirical Banking
DEPARTMENT OF ECONOMICS AND BUSINESS

AARHUS UNIVERSITY DENMARK
Empirical Banking
by
Lene Gilje Justesen
A PhD thesis submitted to the School of Business and Social Sciences,

Aarhus University, in partial fulfilment of the PhD degree in
Economics and Business
November 2015
Supervisors:
Jan Bartholdy & Frank Thinggaard
AU AARHUS
UNIVERSITY
Contents
Preface iii
Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii
Summary ix
English summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
Dansk resumé . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi
Chapter 1 Deposit Insurance and Risk Shifting in a

Strong Regulatory Environment 1
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2 Literature Review and Hypothesis . . . . . . . . . . . . . . . . . . . . . 6
1.3 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.4 Research Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
1.5 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
1.6 Controlling for Possible Endogeneity . . . . . . . . . . . . . . . . . . . 33
1.7 Robustness Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
1.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Chapter 2 Bank Lending and Firm Performance:
How do Bank Mergers affect Small Firms? 43
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.2 Prior Literature and Hypotheses Development . . . . . . . . . . . . . . 49
2.3 Data and Key Explanatory Variables . . . . . . . . . . . . . . . . . . . 53
2.4 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2.5 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
2.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Chapter 3 The Effect of Bank Quality on Corporate Customers 75

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
3.2 Previous Literature and Hypotheses Development . . . . . . . . . . . . 81
3.3 Research Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
3.4 Relation Between Bank Quality and Firm Performance . . . . . . . . . 97
3.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
Appendix A Data Description and the Sorting Process 109

A.1 The Dataset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
A.2 Data Sorting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
A.3 Bank Merger Information . . . . . . . . . . . . . . . . . . . . . . . . . 122
Bibliography 125
ii
Preface
In this empirical thesis, I study the importance of bank-firm relationships on credit

availability and firm performance and thereby address some important questions for
which the existing literature has provided inconclusive results. For example, are bank
mergers especially harmful for small firms? When a strong bank takes over a poor per-
forming bank, the customers of the target bank will probably experience changes with
regards to the credit policy and hence, does such change result in lower credit availa-
bility for small firms? Does the monitoring ability of banks differ with the bank’s own
quality suggesting that banks of high quality have corporate customers with higher
performance? Do firms that are monitored by a high quality bank outperform their
peers because these banks are better at monitoring their customers at a continuous ba-
sis and thereby discipline the firms and prevent opportunistic behaviour? Additionally,
I analyse if the introduction of a deposit insurance scheme has an adverse effect on
banks’ risk taking behaviour as theoretically predicted.
The three papers in this thesis are based on unique Danish data on banks and
their corporate customers. Danish data is interesting also from an international per-
spective because SMEs, in terms of the number of firms and the share of employment,
are the key component of the economy making small business financing of utmost
importance. Even so, relatively few studies have made use of microdata on bank-firm
lending relationships and those that have are often faced with data or methodological
limitations.
Denmark offers an ideal setting for conducting my analyses for several reasons.
First, Denmark has a high proportion of SMEs which use bank financing as a primary
source of external financing. Second, most firms have a single bank relation and
therefore the effect of this relation can be isolated in the analyses. Third, the strict
regulation of Danish banks limits the existence of poorly performing banks. Fourth,
the significant wave of bank mergers in the period 2000-2011 reshaped the banking
industry and the relations to corporate customers.
The Danish banking environment consists of a few large banks (Group 1) which
account for approximately 80% of total lending in the banking industry and around
85% of total assets during the period 2000-2011.1 Since 2001 when the largest bank,
Danske Bank, merged with another large bank (BG Bank), this bank alone has ac-
counted for around 50% of total lending and 55% of total bank assets. For comparison,
the four largest banks in Belgium had a market share of 88% in 2003 (DeGryse and
Ongena, 2005), and UK has a similar structure. As a contrast to the Danish bank
market, USA and Italy are among the countries where the largest banks have the lo-
west market share, however, within individual regions the dominance of specific banks
is similarly high (Sapienza, 2002). There are around 12 banks that are classified as
Group 2 banks (the number of banks in the groupings vary over the years) and when
combined with Group 1 banks they represent around 95% of total lending and total
assets until 2005, but from then on, the market share is close to 90%. Similar to
other countries, Denmark has experienced widespread merger activity as well as bank
failures during the financial crisis resulting in a decrease from 208 banks in 2000 to
133 banks in 2011 (see Table 3.2 on page 88). Hence, the Danish banking industry
has a large share of small banks that only account for 5-10% of total lending and
1
The sample period that is relevant for the first chapter in the thesis is described separately in
Deposit Insurance and Risk Shifting in a Strong Regulatory Environment.
iv
they are typically cooperative banks and savings banks. Most bank consolidations
are between small savings banks or cooperative banks and in five cases, one of the
five largest banks is the acquiring bank. Similar to the other Scandinavian countries,
none of the Danish banks are government owned and as of end 2005, there were only
six banks under foreign ownership operating in Denmark despite an absence of entry
restrictions.2 Besides complying with EU-directives and the Basel requirements, Den-
mark is highly regulated and is, for example, one of few European countries where
civil and penal sanctions can be imposed on bank directors and managers.3 Danish
firms maintain relatively few bank relationships.4 In 2000, there are only 3.4% of the
Danish firms that have multiple bank relations and this increases steadily up to 4.2%
in 2007.5 The crisis causes a drop to 3.8% which remains stable throughout the period
ending in 2011.
The aim of the present thesis is to extend our current knowledge along three
dimensions. The first paper tests the classical theory on the possible moral hazard
implications of introducing deposit insurance (Merton, 1977; Black and Scholes, 1973)
and starts 30 years ago when Denmark introduced deposit insurance. Around that
time, Denmark received attention from researchers because of the strict regulation
of financial institutions (Bernard et al., 1995; Pozdena, 1992). To increase financial
stability and avoid bank runs, regulators promote deposit insurance (see for example
Bank for International Settlements (2009)), but the success of implementing such a
scheme is highly dependent on the regulatory environment (Demirgüç-Kunt and Kane,
2002). Denmark serves as a good example for testing and addressing one of the main
counterarguments, i.e. that banks perform risk shifting once the deposits are insured.
We show that the incentive for banks to increase their risk taking after the introduction
2
The minimum capital entry requirement was e8 million as of 2005 (Barth et al., 2008).
3
Other European countries with possible personal sanctions as of 2005 are Spain, Switzerland,
Ireland and Poland (Barth et al., 2008).
4
A bank relation is defined as a current relation with the bank and stems from firms’ financial
statements, hence this is based on everyday activities and not specific loan contracts.
5
These number are based on all the available information on bank relation, i.e. a total of 1.9
million firm-year observations.
v
of deposit insurance is reduced by strong regulation.
The second paper adds to the literature on bank mergers. As mentioned above,
Denmark has seen a large number of bank mergers. This may have consequences for
the corporate customers of implicated banks because different types of banks tend
to serve different customers (Berger et al., 2005). Existing knowledge in this field of
research is rather scarce, at least from the perspective of small corporate customers.
I find that small corporate customers are not affected by bank mergers per se, in
fact there is evidence to suggest that bank mergers may be beneficial for corporate
customers. Specifically, I show that bank mergers result in higher performance of the
implicated firms and that this is not a result of survivorship bias. This finding could
be caused by higher efficiency of the consolidated bank and an increased monitoring
of the corporate customers. There is, however, evidence to suggest that when a large
bank takes over another bank and when banks in the firms’ local area merge, this has
negative consequences for firms in the form of reduced bank debt. This study adds
new evidence to existing literature which is very relevant considering the high number
of bank consolidations internationally. Evidently, bank mergers are not harmful as
such, however, attention is required when a large bank takes over small banks and
when local banks merge as this may result in less competition.
One of the primary roles of banks is to serve as financial intermediaries by transfer-

ring funds from savers (i.e. depositors) to borrowers. In the process of granting loans,
the bank serves as a delegated monitor. Throughout this thesis, bank monitoring is
considered a tool where an active monitoring effort enables the bank to prevent firms
from opportunistic behaviour by adjusting interest rates and contracts terms on an
on-going basis (Mayer, 1988; Berger and Udell, 1995a; Holmstrom and Tirole, 1997).
In this process, the issue of asymmetric information is of great importance especially
in the case of small firms that are informationally opaque by nature. The third pa-
per therefore examines the relation between bank quality and the bank’s ability to
monitor its corporate customers and we address the issue of whether banks actually
vi
do act as monitoring bodies. We hypothesise that banks of high quality are better at
monitoring their customers, especially if the firms’ own internal monitoring is weak
and that this should result in better performance of those firms. The results show no
significant effect of high quality bank monitoring on firm performance per se, but the
monitoring of high quality banks results in higher performance of firms with weak al-
ternative monitoring. Hence, our evidence suggests a substitution effect between bank
monitoring and firms’ alternative monitoring. This finding is related to the conclusion
in the second paper that bank mergers improve banks’ ability to monitor which results
in higher performance of corporate customers.
The readers of this thesis will learn about some of the main issues in banking:
bank runs, deposit insurance, moral hazard, asymmetric information, bank mergers,
small business financing and relationship lending. These keywords sum up some of the
important aspects in this thesis and they are addressed with an empirical approach in
the hope that we will be able to learn from the past.
Acknowledgements
Completion of this doctoral thesis has only been possible with the support of several
people. I would like to express my sincere gratitude to all of them.
First, I would like to thank the assessment committee, Professor Charlotte Øster-
gaard, Professor Ken L. Bechmann, Professor Anders Grosen, for taking the time to
read and evaluate my thesis. Your comments and suggestions have definitely improved
this thesis.
Second, I want to thank my supervisors Associate Professor Jan Bartholdy and
Professor Frank Thinggaard. The process has felt like a roller-coaster ride with many
ups and downs, but I have always felt your strong support. Thank you for many
interesting discussions and for believing in me all the way. I would also like to thank
the accounting and finance research groups for creating a friendly environment where
vii
I always had somewhere to go for some good advice. Additionally, I want to mention
Lars Lund-Thomsen who has been an invaluable help with the data, Ingrid Lautrup
for always helping out with administrative issues and Karin Vinding for fast and highly
qualified proofreading.
With financial support from Aarhus University and the Oticon Foundation, I have
been so fortunate as to spend a semester at Tilburg University. My sincere thanks go
to the whole faculty of the Department of Finance and especially to Professor Hans
DeGryse, Professor Vasso Ioannidou, and Professor Steven Ongena for taking the time
to discuss my research at several occasions. It was a very instructive and inspiring stay
for me, and I found many new good friends and colleagues, who are jointly responsible
for making this a period of my life that I will never forget.
Also, I would like to thank my fellow PhD students, in particular Jeanne Andersen,
Lukas Bach, Tue Christensen, Maria Elbek, Sune Gadegaard and Camilla Pisani.
Thanks for making this a fun journey with just the right amount of cake, beer and
Baileys along the way. I owe a special thanks to my former office mate, David Sloth
Pedersen, for our many fun and interesting discussions, and for your big support.
Additionally, I would like to thank Marie Herly for being a fantastic colleague and
friend. Marie, you were the one who convinced me to pursue a PhD. There were days
when I felt that I shouldn’t have listened to you but you have always been there for
me, both academically and personally, so today I am left only with gratitude.
Finally, I am deeply indebted to my family for being my personal backing group. To
my amazing husband Mikael, thank you for all your support and love, and especially
for taking good care of our baby twins, Mia and Mads, while I was finishing this thesis.
Without your encouragement, I would never have managed to get this far. I love you
all the way to the moon and back.
Lene Gilje Justesen

Aarhus, November, 2015
viii
Summary
This dissertation consists of three independent articles within empirical banking. The
papers are briefly described hereunder.
English summary
In Chapter 1 we provide empirical evidence on the moral hazard implications of in-

troducing deposit insurance into a strong regulatory environment. Denmark offers a
unique setting because commercial banks and savings banks have different ownership
structures, but are subject to the same set of regulations. The ownership structure
in savings banks implies that they have no incentive to increase risk after the imple-
mentation of a deposit insurance scheme whereas commercial banks do. Also, at the
time of the introduction, Denmark had high capital requirements and a strict closure
policy.
Using a difference-in-difference framework we show that commercial banks did
not increase their risk compared to savings banks after the introduction of deposit in-
surance. The results also hold for large commercial banks, indicating that the systemic
risk did not increase either. Thus for a system with high capital requirements and
a strict closure policy, we reject the hypothesis that deposit insurance induces moral
hazard into the system.
Chapter 2 analyses credit rationing of firms following bank mergers, and its pos-
sible long-term implications. Bank mergers are expected to influence small firms more
than large firms as small firms rely more on bank financing, hence they are more
vulnerable to bank shocks.
Using a large Danish dataset, I measure the impact of bank mergers on small
corporate borrowers on two dimensions: the level of bank debt and the operating
performance. I find that bank mergers have no effect on bank debt but surprisingly,
the implicated firms have significantly higher performance after the bank merger than
comparable firms, suggesting increased efficiency of the new consolidated bank. How-
ever, analyses suggest that if the acquiring bank is very large or if the merger takes
place in the firm’s local area, the effect on corporate customers is negative. This
paper adds to existing literature by empirically examining how bank mergers affect
small corporate borrowers and I find no evidence that such an event is harmful and it
may, in fact, be beneficial for the implicated firms if the merger is not large or local.
Chapter 3 examines how banks’ quality affects their ability to screen and monitor
customers. We particularly study the way a bank’s quality impacts the performance
of its corporate customers.
Bank quality is measured by financial stability, CAMELS ratio and financial re-
porting quality. Controlling for the endogenous bank-firm match we do not find a
statistical significant association between bank quality and firm performance. How-
ever, we find that bank monitoring is more important when alternative firm monitoring
is weak, indicating that high quality bank monitoring may function as a substitute for
firms’ alternative monitoring devices.
x
Dansk resumé
I Kapitel 1 præsenterer vi empirisk evidens på, hvordan indskydergaranti påvirker

bankernes moral hazard, når indskydergaranti introduceres i et strikt regulatorisk
miljø. Eftersom de danske banker og sparekasser har forskellige ejerskabsstrukturer,
men er underlagt den samme type regulering, er den finansielle sektor i Danmark
ideel til denne undersøgelse. Ejerskabsstrukturen i sparekasser betyder, at de ikke har
incitamenter til at udnytte moral hazard under indskydergarantiordningen, hvilket
bankerne har. Da indskydergarantien blev introduceret, havde Danmark særligt høje
kapitalkrav samt stramme afviklingsregler.
Vi benytter et forskningsdesign baseret på forskelle mellem to grupper til at vise, at

bankerne ikke forøgede deres risiko sammenlignet med sparekasser efter introduktionen
af indskydergarantien. Dette resultat gælder også for store banker, hvilket vil sige, at
den systemiske risiko heller ikke blev forøget. Derfor kan vi forkaste hypotesen om,
at indskydergaranti forøger moral hazard i et stramt reguleret system.
Kapitel 2 analyserer, om virksomhederne oplever kreditklemmer, når deres bank

fusionerer eller bliver overtaget af en anden bank, samt mulige langsigtede konsekvenser
heraf. Banksammenlægninger forventes at påvirke små virksomheder med kun én
bankforbindelse mere end store virksomheder, fordi de små virksomheder har færre
finansieringsmuligheder og dermed er mere følsomme over for bankchok.
Ved hjælp af et stort dansk datasæt undersøger jeg, hvordan banksammenlægninger

påvirker små erhvervskunder på to dimensioner: effekten på banklån og virksom-
hedernes profitabilitet. Jeg påviser, at banksammenlægninger ikke har indflydelse
på virksomhedernes banklån, men overraskende øges deres profitabilitet, hvilket in-
dikerer en højere effektivitet i den nye, konsoliderede bank. Analyser viser dog, at
hvis det er en af de største danske banker, som overtager en anden bank, eller hvis
banksammenlægningen sker i virksomhedens lokalområde, så har det en negativ effekt
på virksomhederne i den overtagne bank. Denne artikel bidrager til den eksisterende
xi
litteratur ved at påvise, at bankfusioner ikke er skadelige for erhvervskunder i den
overtagne bank, og det kan endda være gavnligt, hvis fusionen ikke er stor eller lokal.
Kapitel 3 undersøger, hvordan bankens egen kvalitet påvirker dens evne til at
monitorere og screene kunder. Vi undersøger, hvordan bankens kvalitet påvirker er-
hvervskundernes præstation.
Bankkvalitet bliver målt som en kombination af bankens finansielle stabilitet,
CAMELS rating og regnskabskvalitet. Når vi kontrollerer for den endogene rela-
tion mellem bank og virksomhed, kan vi ikke påvise en sammenhæng mellem bankens
kvalitet og virksomhedens præstation. Dog finder vi, at bankmonitorering er vigtigere,
når alternative monitoreringsmekanismer fejler. Dette tyder på, at bankmonitorering
af høj kvalitet kan substituere for virksomhedens andre monitoreringsmekanismer.
xii
Chapter 1
Deposit Insurance and Risk Shifting in a

Strong Regulatory Environment
Deposit Insurance and Risk Shifting in a
Strong Regulatory Environment
Jan Bartholdy and Lene Gilje Justesen
Department of Economics and Business Economics

Aarhus University
Denmark
Abstract
This study provides empirical evidence on the moral hazard implications

of introducing deposit insurance into a strong regulatory environment. Den-
mark offers a unique setting because commercial banks and savings banks have
different ownership structures, but are subject to the same set of regulations.
The ownership structure in savings banks implies that they have no incentive
to increase risk after the implementation of a deposit insurance scheme whereas
commercial banks do. Also, at the time of the introduction, Denmark had high
capital requirements and a strict closure policy.
Using a difference-in-difference framework we show that commercial banks
did not increase their risk compared to savings banks after the introduction of
deposit insurance. The results also hold for large commercial banks, indicating
that the systemic risk did not increase either. Thus for a system with high
capital requirements and a strict closure policy, we reject the hypothesis that
deposit insurance induces moral hazard into the system.
Keywords: Deposit insurance, asymmetric information, moral hazard.
JEL Classification: G21.
We would like to thank Ken L. Bechmann, Anders Grosen, Marie Herly, Karolin Kir-
schenmann, Frank Thinggaard, participants at DGPE Workshop 2011, participants at D-
CAF workshop in accounting 2012, participants at the Nordic Finance Research Workshop
2012 and the Finance Research Group at Aarhus University for helpful comments.
3
4 Chapter 1. Deposit Insurance and Risk Shifting
1.1 Introduction
A main concern during a financial crisis is how to prevent bank runs, which is a serious
problem if they spread from one bank to the whole system. Deposit insurance may
be a solution to this problem, as shown by Diamond and Dybvig (1983). Although
deposit insurance removes the incentive for depositors to withdraw their funds from
the banking system, the insurance scheme may also introduce incentives for banks to
become riskier and may thereby increase the risk of the overall banking system. This
is often referred to as moral hazard or the risk shifting hypothesis.1 In practice, this
implies that the costs from failed banks may increase as a consequence of insurance
coverage. However, a strong regulatory environment, in particular strong capital re-
quirements and a closure policy, may alleviate the moral hazard problem from deposit
insurance.
When deposit insurance is introduced, several factors may be responsible for moral
hazard. First, the insurance premium does not fully reflect the risk of the banks’
assets. In some countries, the premium is flat-rate and therefore proportionate with
the volume of deposits and completely independent of the riskiness of the assets.2
Thus risky banks pay the same premium as safe banks, which gives an incentive to
increase risk and hence the expected return.
Second, under deposit insurance the equity holders have a put option written by
the deposit insurance fund. If a bank fails and the funds are insufficient to pay the
depositors, depositors will be paid by the insurance fund. Since the value of an option
increases with the volatility of the underlying asset, management has an incentive to
increase the risk of the bank to maximise the value of the put option to the shareholders
(Merton, 1977).
Third, once depositors are guaranteed their savings, they have no incentive to
1
This risk shifting has a long history, see e.g. Merton (1977); Santomero (1984); Goodman and
Santomero (1986).
2
For a discussion of the various deposit insurance systems in different countries, see Demirgüç-
Kunt et al. (2008).
1.1. Introduction 5
monitor the risk-takings of the bank. Without insurance, the depositors will monitor
and assess the riskiness of the bank and demand an interest rate that compensates
them for the risk. This contrasts the situation with deposit insurance, where the
depositors view deposits as risk free and only demand the risk free rate of interest
regardless of the risk of the bank. The bank can therefore fund itself at the risk free
rate and invest in risky assets.
There are several ways to mitigate the problem of moral hazard or a potential
risk shifting. In theory, moral hazard is reduced or eliminated by a risk adjusted
premium on the insurance, but in practice it is not possible or not desirable to price
deposit insurance fairly because of private information (Chan et al., 1992; Freixas and
Rochet, 1998). Introducing deposit insurance into a strong regulatory environment
may prevent shareholders from shifting the cost of their risky actions to the depositors.
Finally, putting a cap on the insurance means that the uninsured depositors will
monitor and demand a risk premium on large deposits, curtailing the gains from, and
the incentive to increase risk.
The introduction of formal deposit insurance in Denmark in 1988 presents a unique
opportunity to test the risk shifting hypothesis in a strong regulatory environment.
The Danish system had a flat rate and thus creates an incentive for moral hazard.
However, only deposits up to approximately $ 36.000 were insured, reducing the moral
hazard incentive.3 From an econometric point of view, the existence of savings banks
under the same set of regulation as commercial banks makes it possible to utilise
a difference-in-difference approach since savings banks have no incentive to increase
risk whereas commercial banks have (see Section 1.2.2). Hence, in our analyses the
commercial banks act as the treatment group and the savings banks as the control
group.
We find that commercial banks on average did not increase their risk at the in-
troduction of deposit insurance. The results also hold for large financial institutions
3
Special deposits such as pensions were also insured.
so the systemic risk did not increase either. Controlling for the endogenous choice of
savings banks to convert into commercial banks, also show no significant difference
between the attitude towards risk after deposit insurance is introduced. These results
are confirmed by performing an analysis on debt to equity ratios of individual firms
financed by commercial banks and savings banks, respectively, utilising that for each
firm we can identify their banking connection. If commercial banks take more risk,
they would invest more in risky projects and this would translate into higher debt
ratios for corporate customers. This test confirms our main result that introducing
deposit insurance into a strong regulatory environment does not lead to moral hazard.
The paper is organised as follows. We first present a literature review, the hy-
pothesis of analysis and outline the institutional setting. Section 1.3 describes the
data and the measures of bank risk. In Section 1.4, we present the empirical model
and the results are presented in Section 1.5. Next, Section 1.6 shows the results of
the instrumental variables regression followed by the test of robustness in Section 1.7.
Finally, Section 1.8 concludes.
1.2 Literature Review and Hypothesis
The main motivation for introducing deposit insurance is to increase financial stability,
hence to prevent sudden financial panics and bank runs. However, research shows that
the success of deposit insurance is highly dependent on the implementation and the
institutional environment in which the scheme is introduced (see, for example, Cull
et al. (2005), Demirgüç-Kunt and Kane (2002) and Laeven (2002)).
A relatively large body of literature has tested the moral hazard hypothesis, i.e.
the risk shifting by banks to the deposit insurance fund. US based research finds a
positive relation between bank failure rates and the introduction of deposit insurance
in the 1920s (Wheelock, 1992; Wheelock and Wilson, 1995; Alston et al., 1994), as
well as higher risk takings (DeLong and Saunders, 2011). With focus on the savings
1.2. Literature Review and Hypothesis 7
and loans crisis in the US during the 1980s, research has found similar results with
respect to moral hazard (Kane, 1989; McKenzie et al., 1992; Cole, 1993). Additionally,
Grossman (1992) finds an increase in risk over time for newly insured thrift institu-
tions. These results have also been confirmed on non-US data showing that countries
with high deposit insurance coverage experience more banking crises (Kam, 2011;
Demirgüç-Kunt and Detragiache, 2002). Based on cross-country data, Hovakimian
et al. (2003) find that deposit insurance has adverse effects in countries with low po-
litical empowerment and high corruption. Hovakimian and Kane (2000) analyse the
period 1985-1994 in USA and conclude that capital requirements could not prevent
risk shifting by banks. Additionally, studies using option pricing theory have linked
moral hazard to the mispricing of deposit insurance where Marcus and Shaked (1984)
find that insurance is overpriced, and Duan et al. (1992) find evidence that some
banks indeed do shift their risk to the insurance fund. Additionally, Bartholdy et al.
(2003) find that the risk premiums on large uninsured deposits are higher in uninsured
countries compared to insured countries, indicating that financial markets are aware
of the moral hazard problems. Similarly, when announcing the introduction of deposit
insurance, the stock market reaction to large listed banks is positive (Bartholdy et al.,
2004).
The effect of deposit insurance on moral hazard may be mitigated through regu-
lation. Grossman (1992) exploits differences in regulatory regimes across US states
in the 1930s and finds that thrifts that operate under more permissive regimes were
more risky than those operating in more restrictive regimes. Demirgüç-Kunt and De-
tragiache (2002) find that countries with weak institutional environments are more
exposed towards the adverse effects of introducing deposit insurance, hence they sug-
gest that the moral hazard implication inherent in explicit deposit insurance may be
less of a problem when introduced into a strong regulatory environment.
Another strand of research analyses the link between risk taking behaviour and
the ownership in commercial banks and savings banks, where savings banks have no
incentive to exploit risk shifting whereas the shareholders in commercial banks gain
from risk shifting. Consistent with this, Karels and McClatchey (1999) find that
deposit insurance did not lead to increased risk taking in the credit union industry
in the US during the 1970s. Stock owned mutual savings and loans institutions are
found to be more risky than institutions under mutual ownership, however, both
types of institutions increased their risk following deregulation (Esty, 1997; Fraser and
Zardkoohi, 1996). Also, mutual savings and loans institutions shifting from mutual
ownership to stock ownership increased their risk (Cordell et al., 1993; Esty, 1997).
Consistent with this, Iannotta et al. (2007) find that European mutually owned banks
have better loan quality and lower asset risk than privately owned banks. Similar to
our study, García-Marco and Robles-Fernández (2008) analyse if Spanish commercial
banks and savings banks have different risk taking behaviour.4 Their analyses show
that compared to savings banks, commercial banks are willing to take higher risk,
which they attribute to the moral hazard stemming from deposit insurance.
Prior literature shows that moral hazard is a problem when deposit insurance is
introduced, that regulation may reduce this risk shifting behaviour of banks and that
mutually owned institutions take less risk than institutions owned by stockholders.
This study contributes to this existent literature by providing empirical evidence that
the moral hazard implications inherent in a deposit insurance scheme is reduced when
introduced into a strong regulatory environment with high capital requirements and
a firm closure policy.
In this paper, we exploit the fact that Danish commercial banks and savings banks
are under the same regulation but have different ownership structures. The difference
is that shareholders (decision-makers) in commercial banks have the residual right to
the cash flow from the bank whereas the guarantors in savings banks do not. Therefore
the shareholders in a commercial bank have an incentive to increase risk because this
4
As in Denmark, the main difference between commercial banks and savings banks in Spain is
the ownership structure. In Spanish savings banks, the governing body is controlled by depositors,
employees and local government.
increases the expected return contrary to decision-makers in savings banks who are
more interested in a sound financial business plan because they do not gain from
increased risk and potential higher returns (see Section 1.2.2 for further details).
Before the introduction of deposit insurance, the Danish banking industry had
only experienced few failures (and even fewer with losses to depositors), however,
Denmark did not operate a system with implicit deposit insurance.5 Thus, from
the viewpoint of the financial institutions, deposit insurance was introduced into an
uninsured system.6 Due to their ownership structure it is optimal for commercial
banks to increase risk and thereby increase the risk of the financial system in such
an environment. However, Denmark had a strong regulatory system in the period
around the introduction of deposit insurance that was characterised by high capital
requirements and a firm closure policy (this is further explained in Section 1.2.3). This
is expected to curtail the risk shifting behaviour of commercial banks.
This leads us to the hypothesis of analysis.
H0 : In an environment of high capital requirements and strict firm closure policy,
commercial banks do not increase their risk after the introduction of deposit insurance.
1.2.1 The Institutional Setting in Denmark
Until 1975, the regulation for the commercial banks and the savings banks differed
in that savings banks were restricted in the type of business they were allowed to
undertake.7 In principle, savings banks were not allowed to issue loans unless they
5
This is confirmed by interviews with Eigil Mølgaard and Lars Eskesen as well as by the
bankruptcy of C&G Banken in 1987/88 that resulted in losses for depositors. Lars Eskesen was
Chairman of the Danish Savings Banks Association from 1985 to 1989 and Eigil Mølgaard was the
director of the Danish Financial Supervisory Authority from 1988 to 1996.
6
Because of a possible too-big-to-fail issue, we perform the analyses on small and large banks,
separately. If some banks were too-big-to-fail, then the introduction of deposit insurance would not
lead to any change in behaviour.
7
Pozdena (1992), Bernard et al. (1995) and Bartholdy et al. (2004) provide a description of the
Danish regulatory system during the period. Eigil Mølgaard, head of the Supervisory Authority
during the period, provides a narrative of the regulatory authority during the period 1987 to 1995 in
Mølgaard (2003). The regulation in force at the time published on August 15, 1985 can be found at
https://www.retsinformation.dk/forms/R0710.aspx?id=66156 (Accessed on Aug. 14, 2015).
were completely safe and loan losses were therefore rare in savings banks.8 Due to
this restriction, savings banks provided loans at low interest rates and long maturities
to e.g. local authorities. With increasing interest rates, the funding costs increased
and because of these fixed low loan rates, the earnings problems in savings banks
started. Although savings banks also had some advantages over commercial banks,
for example they were exempt from paying taxes and had lower capital requirements,
they had significantly lower growth rates. Right after the Second World War, the total
assets of all savings banks and commercial banks were about equal but by 1975, the
total assets of commercial banks were 2.3 times as large (Baldvinsson et al., 2000).
In the Act of 1974 (which came into effect in 1975), Danish savings banks came
under the same set of regulations as the commercial banks.9 Savings banks could now
offer the same services as the commercial banks and the only remaining regulatory
difference was a restriction in term of ownership structure. This would prevent savings
banks from raising capital on financial markets, limiting their growth opportunities.
The ownership restriction was removed in 1988 making it possible for savings banks
to convert to joint-stock ownership. In 1988, there were 76 independent banks and
138 savings banks.10 During the 1990s, ten savings banks converted to joint-stock
companies including the five largest that represented about 85% of total assets of all
savings banks (Baldvinsson et al., 2000).
Overall, the Danish banking system was highly regulated up to about 1980. In
particular, there were restrictions on the amount of corporate and private lending
referred to as a "lending ceiling". This restricted internal growth, hence the only way
of growing was by acquiring other institutions. Institutions in distress were obvious
targets and, given the restrictions, the distressed banks had a clear incentive to be
8
Other restrictions included prohibitions on securities trading and currency and foreign transac-
tions.
9
Danish financial institutions faced few restrictions. They could provide stock brokerage, in-
vestment banking and merchant banking services. Finally, there were no geographical or branching
restrictions.
10
The numbers are from the 1988 annual report from the Danish Financial Supervisory Authority
and includes commercial banks and savings banks on Greenland and the Faroe Islands.
acquired. Thus until 1980 all distressed banks in Denmark were acquired by other
institutions.
After 1980, the financial system was liberalised. In particular the lending ceiling
was gradually reduced and completely removed in 1985. With this deregulation it also
became possible to open new institutions or simply change the strategy, for example
to offer high rates on deposit and invest in high risk projects. Additionally, foreign
funding and deposits increased during the 1980s.11 Hence, the removal of the lending
ceiling, the liberalisation of the barriers to entry, and the access to foreign funds made
it easier to obtain internal growth, which reduced the need for acquisitions. At the
same time, the liberalisation and competition from abroad required restructuring and
consolidation of the industry and as a result the savings banks were consolidating
small local savings banks into regional institutions.
Thus until 1980, institutions in distress were in general closed with positive equity
and acquired by other banks. After deregulation, new high risk institutions had opened
and some of these went into distress. However, where the existing institutions were
willing to acquire banks in distress before the deregulation, that was not the case
any more. Presumably because equity was negative and the acquirer therefore had
to compensate both depositors and creditors. Even though one can view high capital
requirements and firm closure policy as substitutes for deposit insurance, they were not
strong enough to prevent failures by the end of the 1980s. A formal deposit insurance
scheme was therefore not relevant before 1980, but developments in the 1980s showed
that Denmark might have a weak implicit insurance scheme, but extent of that scheme
was unclear as to which institutions were covered.12
In 1986 the European Commission recommended that all countries without a de-
posit insurance system should establish one, and the Danish deposit insurance scheme
11
For large banks, foreign funding (deposits) increased from 15% of total assets in 1981 to 25% in
1989. For the medium-size banks it increased from 5% to 15%.
12
These are personal views of the authors based on interviews with Lars Eskesen and Eigil Møl-
gaard.
went into effect in February 1988. A fund was established covering deposits in com-
mercial banks, savings banks, branches of foreign banks as well as deposits in other
financial institutions. The financing came from a levy on total deposits. The maxi-
mum insured limit was DKK. 250.000 (approximately $ 36.000). In case of a large
default and insufficient funds in the scheme, the insurance fund could borrow with
government guarantee.13 From 1988 until 1995, the insurance fund covered deposits
in eight smaller commercial banks and savings banks.14
Table 1.1 on the next page shows the ten largest commercial banks and savings
banks in 1988. Den Danske Bank was the largest bank with a share of the total
assets for all commercial banks and savings banks of nearly 17%. The largest savings
bank, SDS, had a share of 10%. However, by 1995 the only existing savings bank in
top ten was Sparekassen Kronjylland, as the other savings banks had either merged
or converted to joint-stock companies (i.e. become commercial bank). By 1990, the
market share of Den Danske Bank had increased to about 35% due to a large merger
(see Table 1.1). For the commercial banks in top ten, Den Danske Bank, Jyske Bank,
Sydbank and Arbejdernes Landsbank still exist in 2015. In 1988 there were about
40 banks per million inhabitants in Denmark whereas in the US there were 60 banks
per million (partly due to branch restrictions) (Pozdena, 1992). The level of market
concentration and branch coverage suggest that no institution had monopoly power.
The lack of foreign banks suggests that the Danish banks were also efficient.15
13
See Bartholdy et al. (2004) for further details about the insurance scheme and its introduction
in Denmark.
14
C&G Banken, Fossbankin, Lannung Bank, Samson Bankier, Benzon Bankier, Højderyggens
Andelskasse, Grølsted Andelskasse and Lindknud-Hovborg Andelskasse. Information is based on the
annual report from the Deposit Insurance Foundation (1995).
15
Despite unrestricted entry, the share of foreign bank assets in Denmark was only about 1%
around introduction of deposit insurance (Pozdena, 1992).
Table 1.1: The ten largest banks and savings banks by total assets in 1988
Total Assets Equity
Bank type US $ % of own type % of all US $ % of TA
Commercial banks
Den Danske Bank1 24,154 23.05 16.97 1,548 6.41
Handelsbanken1 17,611 16.81 12.37 1,056 6
Privatbanken2 14,134 13.49 9.93 852 6.03
Provinsbanken1 9,159 8.74 6.43 581 6.34
Jyske Bank 8,725 8.33 6.13 493 5.65
Andelsbanken2 8,242 7.87 5.79 543 6.59
Sydbank4 3,342 3.19 2.35 192 5.74
Varde Bank3 2,275 2.17 1.6 162 7.12
Arbejdernes Landsbank 1,974 1.88 1.39 162 8.21
Aktivbanken4 1,735 1.66 1.22 146 8.43
Savings banks
SDS2, 11 14,348 38.17 10.08 839 5.85
Bikuben6, 8 8,722 23.2 6.13 591 6.77
Nordjylland5 3,264 8.68 2.29 215 6.58
Sydjylland7, 10 2,785 7.41 1.96 181 6.51
DK-Sparekassen6 1,169 3.11 0.82 -4 -0.3
Amtssparekassen Fyns Amt9 1,085 2.89 0.76 68 6.27
Sønderjylland10 986 2.62 0.69 72 7.34
Bornholm11 350 0.93 0.25 32 9.21
Kronjylland 331 0.88 0.23 51 15.31
Skive12 287 0.76 0.2 48 16.61
The table shows the ten largest banks and savings banks measured in million US $ in
1988 including a partial list of bank mergers and identification of the savings banks that
converted to a bank. Only mergers between banks and savings banks are included. % of
own type gives the fraction of total assets compared to the group of banks of the same type
(i.e. either a commercial or a savings bank). 1) Handelsbanken, Den Danske Bank and
Provinsbanken ”merged” in 1990, 2) SDS, Privatbanken and Andelsbanken merged to form
Unibank in 1990, 3) Varde Bank went bankrupt in 1994, 4) Aktivbanken was acquired by
Sydbank in 1994, 5) Sparekassen Nordjylland converted into a bank in 1990 and acquired
Himmerlands Banken in 1993, 6) DK-Sparekassen was acquired by Bikuben in 1989, 7)
Sparekassen Sydjylland merged with Bikuben in 1991, 8) Bikuben converted to a bank
in 1995, 9) Amtssparekassen Fyns Amt converted to a bank in 1991, 10) Sparekassen
Sønderjylland was acquired by Sydbank in 1990, 11) Sparekassen Bornholm was acquired
by SDS in 1989 and 12) Skive Sparekasse converted to a bank in 1989.
1.2.2 Ownership Structure
Denmark has a three-tier system with an executive and a separate supervisory board
which is common for both types of banks, and then either an annual general meeting
(commercial banks) or the committee of representatives (savings banks).
Commercial banks have joint-stock ownership, hence they are under the Companies
Act.16 The highest authority of a commercial bank is the annual general meeting where
the shareholders have voting rights. Banks can have ceilings on the votes by individual
shareholders, which increases the dispersion.17 As in other joint-stock companies, the
shareholders have the residual claim to the cash flow from the bank.
Contrary to commercial banks, savings banks have no owners with residual cash
flow rights, because the institutions are self-governing.18 Their capital comes from
two sources, namely retained earnings and guaranteed capital. Guaranteed capital re-
sembles both bonds and equity. The savings bank pays a fixed interest to the guaran-
tor and both the interests and incentives of the guarantors are therefore like those
of bond holders in a joint stock company. However, they also resemble equity since
the guarantors have voting rights. Savings banks are required to have a committee
of representatives, which corresponds to the annual general meeting of banks. This
committee consists of at least 21 members who are elected by either depositors, depo-
sitors together with guarantors, or by guarantors alone. One depositor has one vote,
whereas a guarantor has one vote for every DKK 1,000 paid as guaranteed capital,
however, with a maximum of 20 votes (Jensen and Nørgaard, 1976). Thus, because
the "owners" or decision makers in savings banks have no claim to the yearly profits,
their interests and incentives resemble the depositors and bond holders in commercial
banks.19
16
The specific law for limited and shareholder companies.
17
As shown by Iannotta et al. (2007), a higher ownership concentration in banks leads to lower
asset and insolvency risk, hence a high dispersion is most likely related to higher risk taking.
18
Savings banks tend to use their profits to support activities in the local community.
19
During the time period in question, the management of commercial banks and savings banks
did not have performance dependent pay in the form of option programs etc.
1.2.3 Capital Requirements and Closure Policy
In a perfect regulatory system with no asymmetric information, with continuous mo-

nitoring and where assets and liabilities are reported at market values, there will be
no losses to depositors. If the value of equity in the bank falls below the regulatory
level, then the bank is closed with no losses to creditors and depositors. In such a
system there is no need for deposit insurance. However, the existence of asymmetric
information is a reality and financial institutions are not continuously monitored.
Capital requirements provide a buffer to protect the depositors. High capital re-
quirements and a firm closure policy reduce the potential losses to depositors and also
curtail the incentive for shareholders to pursue high risk since they bear the losses.
Danish banks are regulated by the Danish Financial Supervisory Authority (in
Danish: Finanstilsynet). In the late 1980s, commercial banks and savings banks were
required to maintain a capital to liability ratio of at least 15% to have their profit freely
available for dividend payments.20 The minimum level of capital was 8% and failing
this, the Ministry of Economics and Industry could withdraw the license. The board
and the auditor were required to report to the Supervisory Authority if they believed
that the capital requirement was not satisfied. Additionally, banks were required to
hold 15% of the short deposits in liquid assets, and liquid assets should be at least
10% of the loans. If these requirements were not met, the banks should report to the
Financial Authority within eight days; otherwise it could lead to personal fines and
imprisonment.
The strong capital requirements were supported by mark-to-market accounting,
that is, the balance sheet must be shown at actual or commercial value.21 For traded
20
Capital is equity plus certain forms of subordinated debt where 40% of the capital could be
provided from subordinated debt. According to Bernard et al. (1995), the capital to liability ratio
can be converted to a capital to assets ratio by α/(1 + α), resulting in a 13% capital to asset
requirement for Denmark. For comparison, US commercial banks had an average of 6.21% capital to
asset ratio in 1989 (Berger et al., 1995)
21
Bernard et al. (1995) highlight mark-to-market accounting to be one of the main reasons for the
success of the Danish banking system.
stocks and bonds, the banks were required to use market values from the Copenhagen
Stock Exchange. Considering that real estate financing is based on mortgage bonds
trading on the stock exchange, and banks hold a large proportion of these bonds, a
large part of the bank’s balance sheet constitutes traded assets. For non-traded assets,
banks were required to make adjustments in the booked value in case of changes in
interest rates, exchange rates or any general changes in values. Individual loans must
be written down if the banks either expected losses or have had actual losses.
In 1988, the largest commercial banks and savings banks had a relatively strong
capital position and combined with a firm closure policy by the Supervisory Authority
this ensured that few banks went bankrupt during the banking crisis of the 1990s.22
Denmark entered a turbulent period around 1990 with a banking crisis and opening
of markets in the EU, which led to the closure of 102 financial institutions, however,
most ended up being acquired by another institution. Out of these 102 institutions,
51 were in financial distress and the Supervisory Authority was involved in 47 of these
cases (Mølgaard, 2003, p. 67). The first Danish bank went bankrupt in 1987/88, and
a total of ten financial institutions went bankrupt during the period 1988 to 1995,
but they were all small institutions that required limited payouts from the insurance
fond.23 The rest of the distressed banks were closed and re-opened "the next day" as
part of the acquiring bank with no losses to the depositors.
From 1991/92 the Danish banking system adopted the risk based Basel I system,
which in effect resulted in lower capital requirements for Danish banks.
22
Equity was 6-8% for the commercial banks and 5-17% for the savings banks.
23
C&G Banken, Fossbankin, Lannung Bank, Samson Bankier, Benzon Bankier, Højderyggens
Andelskass, Grølsted Andelskass, Lindknud-Hovborg Andelskass, Bornholmerbanken and Himmer-
landsbanken (Mølgaard (1993), and the annual report from Deposit Insurance Foundation 1995).
1.3. Data 17
1.3 Data
The analyses include Danish commercial banks and savings banks between 1985 and
1990, where the deposit insurance scheme was approved in the parliament in December
1987, and went into effect in February 1988.24 The data is hand-collected from annual
reports from the Supervisory Authority.
Table 1.2 shows the total number of commercial banks and savings banks in Den-
mark divided in size categories as defined by the Supervisory Authority. The decline
during the period is primarily caused by mergers between the two types of banks. We
can see from the table that there are no commercial banks in the "very small" group.
Hence, we have excluded the "very small" savings banks from the analysis because no
comparable commercial banks exist. After 1988 some of the savings banks converted
to commercial banks (i.e. joint-stock ownership), and these are coded as savings banks
for the years they were savings banks and banks after they changed.
Table 1.2: Number of commercial and savings banks by size in the sample
Commercial banks Savings banks
Year Large Medium Small Total Large Medium Small Very Small Total
1985 6 16 50 72 2 11 79 55 147
1986 6 14 53 73 2 11 82 49 144
1987 6 14 56 76 2 10 81 47 140
1988 6 12 54 72 2 9 41 83 135
1989 8 12 53 73 0 5 43 76 124
1990 2 11 58 71 0 1 44 71 116
Data is from annual reports from the Supervisory Authority 1985-1990, and the size categories
are based on the definitions in these reports.
A summary of the aggregate balance sheet information for Danish banks is provided
in Table 1.3 on the next page. We see that all banks in general reduced their loan
portfolio after the introduction of deposit insurance, increased their deposits with more
than one month to maturity and reduced their deposits with less than one month to
24
See Bartholdy et al. (2004) for an overview of the events around the introduction of deposit
insurance.
Table 1.3: The balance sheet composition before and after deposit insurance

Large Small Large Small
Pre Post Pre Post Pre Post Pre Post
In % of total assets
Cash 0.94 1.37 0.86 0.83 0.81 1.00 0.63 0.74
Dep. central bank 0.63 2.05 0.35 1.09 0.49 0.84 0.45 0.45
Dep. domestic banks 4.45 4.78 6.63 4.97 6.04 5.29 5.77 5.51
Dep. foreign banks 13.00 13.56 1.70 0.90 7.34 3.24 0.05 0.03
Inv. in debt securities 16.94 20.93 19.94 24.37 16.31 20.90 25.10 30.53
Inv. in stocks 3.21 2.75 3.66 2.87 2.27 2.02 2.32 2.33
Loans 42.12 38.07 45.66 41.19 50.72 48.81 45.15 44.32
Fixed assets 1.41 1.46 1.93 2.07 1.96 2.19 2.88 2.72
Other assets 17.34 15.06 19.35 21.79 14.06 15.72 17.66 13.36
In % of total liabilities
Dep. (<1 month) 24.27 24.73 25.05 22.72 25.98 23.41 29.35 24.55
Dep. (<12 months) 7.20 10.17 9.55 9.77 8.33 11.11 12.5 12.66
Dep. (> 12 months) 1.14 2.45 3.89 7.24 2.54 7.19 5.68 14.25
Other dep. 12.86 9.36 11.71 8.10 14.37 12.29 14.77 12.54
Debt to domestic banks 4.63 8.48 12.58 15.71 6.58 8.04 4.14 6.18
Debt to foreign banks 23.51 20.67 4.29 2.28 18.41 10.41 0.78 0.00
Guarantees issued 12.43 11.07 14.63 18.4 8.57 10.34 13.60 11.08
Other liabilities 6.01 5.00 6.52 5.19 6.22 7.89 6.19 5.50
Subordinate debt 2.00 1.93 1.53 1.22 2.73 2.36 1.96 1.99
Equity 5.94 6.14 10.24 9.36 6.28 6.96 11.03 11.24
Pre is the average of the years 1985, 1986 and 1987 and Post is the average of the years
1988, 1989 and 1990. Large is group 1 and 2 banks, and Small are group 3 banks. Data
is from annual report from the Supervisory Authority, 1985-1990.
maturity. This contrasts Carapella and Giorgio (2004) who find that banks increased
their lending after the introduction of deposit insurance across 55 countries and since
the increase in loans was not backed up with a similar increase in deposits, they
confirm the moral hazard hypothesis of an increase in risk taking after the introduction
of deposit insurance. Foreign funding as well as deposits with foreign banks have
generally decreased. Finally, the amount of equity increased for all institutions. Based
on these descriptive statistics, there is no clear picture of increased risk takings by
commercial banks compared to savings banks.
1.3. Data 19
1.3.1 Measures of Bank Risk
The primary focus of this paper is to see whether commercial banks increased their
risk compared to savings banks after the introduction of deposit insurance. In general,
there are two ways of estimating risk; either capital market measures of risk (see e.g.
Saunders et al. (1990); Konishi and Yasuda (2004)) or accounting based risk measures.
Since only some banks are listed (and none of the savings banks), we cannot use
capital market measures and we therefore derive risk proxies from the balance sheets.
Besides the financial statements, we also have information on those banks that went
into financial distress during the period 1985 to 1995 from Mølgaard (2003). Over
the period 1985 to 1992, there were 39 institutions that went into financial distress
and closed, but in nearly all the cases they were subsequently acquired by another
institution with no losses to the depositors.25 One could look at the difference in
proportion of institutions in distress between commercial banks and savings banks
before and after the introduction of deposit insurance, however, we want to analyse
the risk taking of banks irrespective of whether they succeeded or failed.
We estimate risk using the following three step procedure. First, we construct a set
of potential risk proxies based on the annual reports. Second, we use a logistic model
with a binary variable indicating distress to identify the measures that can proxy for
distress risk. These individual measures are then used in the difference-in-difference
analysis. Third, we estimate a logistic model with a binary variable indicating distress
as the dependent variable and all the identified risk proxies from step 2 as explanatory
variables. The predicted values from this model are then used as a composite measure
of risk, i.e. the D-score.
We propose a set of risk measures from the financial statements of the banks.
Besides using economic intuition and the existing literature, we also test if these
25
C&G Banken, Lannung Bank, Højryggens Andelskasse and JAK Andelskassen Grølsted were
closed and losses to depositors were covered by the insurance fund. Only the first two banks are
included in the sample since the last two are savings banks in the "very small" category.
measures do indeed proxy for risk. The basic idea is that any proxy for risk should
have predictive power with respect to financial distress. We therefore estimate the
following model to find a set of risk measures to be used in the analysis of risk behaviour
around the introduction of deposit insurance. Specifically, we estimate the probability
of distress as the following.
Distressit =β0 + β1 lnT Ait−1 + β2 ROAit−1 + β3 U nempt−1 + β4 N BRatet−1 +

(1.1)
β5 IntLongt−1 + β6 GDPt−1 + j
β7 Riskit−1 + it
Where Distress is a binary variable of 1 if the bank is in financial distress, 0 other-

wise.26 Riskit−1
j
is the individual proxy for risk, j, derived from the annual reports.
We estimate a logit model for each risk measure over the period 1985 to 1990.
The various risk measures are presented in Table 1.4 on the facing page. The size
of the bank, measured by the logarithm of assets, is included as a control variable.
Prior research shows that large banks lend a greater fraction of their assets than the
small banks do, but research also suggests that large and small banks serve different
borrowers. The small banks tend to lend more to small and less established companies
based on soft information, whereas larger banks tend to lend more to large and well
established firms (Thakor and Boot, 2008). Generally, large banks are more diversi-
fied than smaller banks, but Demsetz and Strahan (1997) find that large bank holding
companies use their advantage of diversification to engage more in risky, potentially
high return lending. The return on assets (ROA) is included in the model to cap-
ture the effect that institutions with low earnings are more likely to go into financial
distress. Finally we also include macroeconomic variables which could have an effect
on bank behaviour: the rate of unemployment (U nemp), the banks’ interest rate at
26
Banks in distress are obtained from Mølgaard (2003). Eigil Mølgaard was director of the Su-
pervisory Authority from 1988 to 1996. He lists all banks and savings banks that closed due to
acquisitions and/or financial distress during the period from 1985 to 1995 (Mølgaard, 2003, Fig. 2,
p. 64). Thus our sample is limited to that period only.
1.3. Data 21
Table 1.4: Estimation of risk proxies
Risk variable Full sample Large banks Small banks

Loans/TA 2.51 1.23 2.95
Loans/Dep. 0.95*** 3.34*** 0.73***
Equity/TAa -17.94*** -58.78 -12.5**
Bonds/TA -12.15*** -20.70* -11.55***
Mortgage deeds/TA 5.30 -35.58 6.76
ShortDep./Loansb -0.40 -25.64** -0.05
LongDep./Loansc -8.10*** -6.55 -8.85***
SpeDep./Loans -7.85*** -21.40** -6.51***
ForeignDep./Loans 0.77 29.17* 0.46
LLP/Loansd 26.44*** -41.14 30.91***
GL FX/TAe 37.2** 297.21 -34.04
Cash plus dep. in banks/TA -1.15 25.49*** -3.75
Overdraft facilities/Loans 1.00 -3.96 1.82
BillsExc./Loansf 5.53** 17.28 5.29**
B.Loans/Loansg 9.82** -34.97 12.25***
Mortgage loans/Loans -0.25 -17.68 0.27
Other loans/Loans -1.83 8.47* -3.60**
(Cap.GLh /TA)2 -3233.60*** 20977.56** -1612.09
No banks in distress 33 6 27
The table shows various measures of risk which are tested individually on the
probability of bank distress (see Equation 1.1). The estimates are shown for the full
sample of financial institutions as well as for large (group 1 and 2) and small (group
3) institutions, respectively. The estimation period is from 1985 to 1990. a) Equity
is the sum of capital and reserves, b) ShortDep. are deposits with maturities of less
than 1 month, c) LongDep. are deposit with maturities of more than 12 months,
d) LLP is loan loss provisions, e) GL F X is gains and losses on foreign currency,
f) BillsExc. are bills of exchange, g) B.Loans is building loans and h) Cap.GL is
capital gains or losses. Variables in bold are those selected for further analyses.
the Danish National Bank (N BRate), the ten year interest rate on government bonds
(IntLong) and gross domestic product.
As expected, Table 1.4 shows, that the ratio of loans to deposits is significant, that
is, the size of the loan portfolio increases the default risk of the financial institution.
Likewise, equity to assets is significant, showing that an increase in the ratio reduces
the probability of default, which is also expected.
In Denmark, most mortgage financing is done using mortgage backed bonds issued
by specialised mortgage institutions.27 The bonds are traded on the stock exchange,
and they are reported at market values in the bank’s annual report. The majority
of mortgage bonds are fixed rate, issued with a long maturity. Mortgage bonds have
very little default risk since no mortgage institution has defaulted since the origin of
the mortgage system in 1797 hence, the primary risk from these bonds is the interest
rate risk. Thus, the higher the holdings of bonds, the higher the capital gains and
losses caused by changes in interest rates. Because the holding of mortgage bonds and
other financial assets leads to capital gains and losses, we also include the squared
capital gains and losses to total assets, ((CapGainLoss/T A)2 ), corresponding to the
volatility of investments. Contrary to expectations (Lepetit et al., 2008; Cebenoyan
and Strahan, 2004), the coefficient on Bonds/TA is negative and thus high investments
in bonds reduce the risk of distress, and similarly (CapGL/T A)2 is also significantly
negative for the full sample but significantly positive for large institutions.28 These
findings are probably a period specific result since the long interest rate on government
bonds fell from nearly 12% to 9% over the sample period, which led to capital gains
to financial institutions holding these bonds.
The four variables of deposit (short, long, special and foreign deposits over total
loans) measure the funding risk. Holding deposits with long maturity (deposits with
maturity of more than 12 months and special deposits) reduces the risk of financial
distress by reducing the funding risk. Wheelock (1992) finds that the lower the vari-
ables surplus to loans, bonds to assets, reserves to deposits and deposits to assets, the
higher the likelihood of bank failure, based on an analysis of the voluntary deposit
insurance in Kansas in the 1920s, which is somewhat consistent with our results. Loan
loss provisions are also significantly positive. An increase in loan loss provisions is a
27
We also see building loans and mortgage loans on banks’ financial statement, because while
building a house, customers take up a building loan which they afterwards may (partly) convert to
a mortgage loan in the bank. The majority of mortgage loans in Denmark are, however, placed at
specialised mortgage institution.
28
For small institutions it appears that the (CapGL/T A)2 has a negative coefficient, suggesting
that these institutions used financial instruments to hedge against risk whereas the large institutions
used them for speculative purposes.
1.3. Data 23
sign of risky behaviour because increased investments in risky projects results in an

increase in LLP (Lepetit et al., 2008). From the measures for different types of loans
only the ratios bills of exchange to total loans and building loans to total loans are
significant.
Based on the results in Table 1.4, we have identified the following proxies for
risk: Total loans to total deposits (Loans/Dep.), equity to total assets (Equity/T A),
bonds to total assets (Bonds/T A), deposits with maturity more than 12 months to
total loans (LongDep./Loans), special deposits to total loans (SpeDep./Loans), loan
loss provisions to total loans (LLP/Loans), gains and losses on foreign currency to
total assets (GL F X/T A), bills of exchange to total loans (BillsExc./Loans), building
loans to total loans (B.Loans/Loans) and the square of capital gains and losses to
total assets ((CapGL/T A)2 ).
Next, we use the ten risk proxies identified in Table 1.4 as explanatory variables and
estimate a logistic model with a binary dependent variable indicating distress (from
Mølgaard (2003)). The predicted values from this model are used as a composite
measure of risk for each individual institution. The analyses are then re-estimated
based on this aggregate risk proxy.
Specifically, we estimate the following logistic regression (similar to Equation 1.1).
Distressit =β0 + β1 lnT Ait−1 + β2 ROAit−1 + β3 U nempt−1 + β4 N BRatet−1 +

(1.2)
β5 IntLongt−1 + β6 GDPt−1 + β Riskit−1 + it
0
Where Risk contains the ten proxies identified in Table 1.4. The predicted probabilities
from the model are used as an aggregate risk measure for the individual banks denoted
as the D-score.
In Table 1.5, the signs of the variables are consistent with the univariate analysis in
Table 1.4. Given that the risk variables are somewhat correlated, some of the variables
Table 1.5: Estimation of the aggregate risk model
Estimate Std. Error Wald stat.

Risk measures
Loans/Dep. 3.12*** 1.14 7.47
Equity/TA -78.04*** 29.82 6.85
Bonds/TA -18.06*** 7.23 6.24
LongDep./Loans 1.09 3.76 0.08
SpeDep./Loans -1.68 6.09 0.08
LLP/Loans 30.45 23.19 1.72
GL FX/Assets -111.05 206.51 0.29
BillsExc./loans 3.38 11.04 0.09
B.Loans/loans 20.17*** 7.80 6.69
(CapGL/T A)2 -480.42 1550.36 0.10
lnTA -0.54 0.35 2.39
ROA 9.39 41.51 0.05
Unemp -1.37 1.50 0.83
NBRate 2.67 2.44 1.20
IntLong -1.31 1.22 1.14
GDP -0.36 0.37 0.93
Constant 13.40 12.62 1.13
Somer’s D 0.91
Goodman-Kruskal Gamma 0.947
Kendall’s Tau-a 0.054
ROC-c 0.955
The table presents results from the analysis of the aggregate risk measure
(see Equation 1.2). See Table 1.4 for a description of the risk measures.
The control variables are banks size (lnTA), return on assets, the unem-
ployment rate, banks’ interest rate at the National Bank, ten year interest
rate on government bonds and gross domestic product. The symbols ***,
** and * denotes significance at 1%, 5% and 10% level, respectively based
on robust standard errors clustered at bank level.
1.4. Research Design 25
Table 1.6: Average D-scores
Group Obs. Mean Std. dev.

Commercial banks
Large 108 0.0374 0.1288
Small 230 0.0383 0.1395
Savings banks
Large 54 0.0279 0.1350
Small 247 0.0188 0.0910
The table presents average predicted default proba-
bilities (D-scores) from the model estimated in Table
1.5. Large is group 1 and 2 banks, and small banks
are in group 3.
are insignificant in the multivariate analysis compared with the univariate analysis.29
In Table 1.6 we show mean values of the probability of bank distress based on the
different size groups of commercial banks and savings banks, respectively. Based on
this aggregate measure of risk we find that small commercial banks on average are
most risky, whereas small savings banks are those with the lowest risk. The predictions
from the model are used as an aggregate measure of risk in the analyses, the D-score.
1.4 Research Design

The primary interest of this study is to test whether banks changed their risk-taking
behaviour after the introduction of deposit insurance. We use a difference-in-difference
approach to test this by exploiting the fact that Danish commercial banks and savings
banks have different incentives to undertake risk due to their ownership structure.
In principle, the difference-in-difference approach should be based on a sample of
(comparable) financial institutions where one sub-sample is randomly assigned to a
deposit insurance scheme (i.e. the treatment group) whereas the other sub-sample
is not (i.e. the control group). This is, of course, not possible and we therefore use
29
Autocorrelation is not a problem in the analysis because we only use the predicted values as
indications of bank distress, hence we do not wish to explain the individual effect of each risk measure.
savings banks as the control group since they have no incentive to increase risk due
to their ownership structure. We then test if commercial banks (the treatment group)
increased their risk after the introduction of deposit insurance compared to savings
banks. All analyses are carried out on the full sample, large institutions and small
institutions, respectively. Large institutions are interesting because if these banks
increase risk, it may result in systemic risk which has consequences for the whole
banking industry. However, since the large banks are mostly commercial banks, we
also show the results based on small institutions separately because the commercial
banks and the savings banks are more comparable in this group.
The first analysis is a univariate model where mean values of the different risk
measures (see Section 1.3.1) from the pre- and post-deposit insurance period (before
and after 1988) are tested for significant changes for commercial banks and savings
banks, respectively, formally stated as follows.

(Risk Commercial
P ost ) − (Risk Commercial
P re ) =0 (1.3)

(Risk Savings
P ost ) − (Risk Savings
P re ) =0 (1.4)
The second test is a multivariate regression model using unbalanced panel data to
analyse whether deposit insurance has an effect on bank risk taking while controlling
for macroeconomic factors that also may influence the risk taking of banks (contained
in the vector Xt ). The main model of analysis is the following.
Riskit =β0 + β1 P ostit + β2 Bankit + β3 P ostit × Bankit + β 0 Xt + it (1.5)
where β1 =(Risk Savings

P re ),
β2 =(Risk Commercial
P re ) − (Risk Savings
P re ) and
h i h i
β3 = (Risk Commercial
P re ) − (Risk Savings
P re )
1.5. Results 27
Where the mean values of risk are calculated in the Post deposit insurance period,
hence from 1988 and after, and Pre denotes mean values in the years up to 1988.
Since we are interested in the difference between commercial banks and savings
banks before and after the introduction of deposit insurance (i.e. the difference-in-
difference), we can first show how the change in risk for commercial banks (Equation
1.3) is included in Equation 1.6.

∆Risk Commercial = (Risk Commercail
P re )
(1.6)
=[β0 + β1 + β2 + β3 ] − [β0 + β2 ] = β1 + β3
Second, the change in risk for savings banks (Equation 1.4) is as follows.

∆Risk Savings = (Risk Savings
P re ) = [β0 + β1 ] − [β0 ] = β1 (1.7)
From Equation 1.6 and Equation 1.7 we see that the difference in risk from the
pre- to post-deposit insurance period for the commercial banks is captured by β1 + β3 ,
and the change in risk for savings banks is the estimator β1 . Hence the difference
between the changes in risk for these two types of banks (the difference-in-difference)
is captured in β3 (as also shown in Equation 1.6), i.e. the interaction term between
P ost × Bank. Recall that although commercial banks have incentives to increase risk
after the introduction of deposit insurance, we expect β3 to be zero because of the
strong regulatory environment in Denmark. Intuitively, the difference-in-difference
approach tests the difference between the pre- and post-period for commercial banks
relative to savings banks while controlling for any general differences between the two
types of banks and general shifts in trends that are common for the two groups.
1.5 Results
First, we perform a univariate analysis of the risk variables before and after the intro-
duction of deposit insurance. The analysis compares the mean values before and after
the introduction of deposit insurance and test for significant differences.
Our presentation is complicated by the fact that an increase in some of the risk
variables reduces risk while an increase in other variables increases risk. Therefore, we
have included the column Impact on P(distress) which shows the sign of the estimate
obtained in Table 1.4 on page 21, i.e. whether an increase in the risk measure increases
or decreases the probability of bank distress. The column Diff. tests if the variable
changed significantly from the pre- to the post-deposit insurance period and Risk shows
whether the bank takes higher (H) or lower (L) risk based on each individual risk proxy.
For example, the bonds to total assets ratio decrease for banks after the introduction
of deposit insurance, since an increase in this variable would cause a decrease in the
risk of the bank (negative sign in the column Impact on P(distress)), this shows that
the banks increased their risk after the introduction of deposit insurance (although
insignificant for savings banks). The banks generally increased their ratios of equity
and special deposits and decreased their bills of exchange and building loans, hence
reducing the risk. The long deposits to total deposits ratio decrease implying higher
risk which is supported by the decrease in the square of capital gains and losses, and
the increase in LLP/Loans. For large institutions, the changes in three out of four
risk measures implies higher risk taking whereas there is a more equal split between
higher and lower risk taking for small banks.
Thus the univariate analysis does not give clear indications of increased risk taking
by commercial banks as a result of the introduction of deposit insurance. Also, the risk
variables for savings banks have, in most instances, the same sign as for banks. Recall,
that deposit insurance gives no incentive for savings banks to perform risk shifting
because they have no owners who will gain from a potential higher return. Based on
the univariate analysis we cannot conclude whether commercial banks increase their
risk more than savings banks or if there is no difference between the two types of
banks and that changes are caused by common external factors. To disentangle this,
we next undertake a difference-in-difference analysis by estimating Equation 1.6 using
OLS with standard errors clustered at bank level.
1.5. Results 29
Table 1.7: Mean values of risk measures pre- and post-deposit insurance
Impact on Commercial banks Savings banks

Risk variables P(distress) Pre Post Diff. Risk Pre Post Diff. Risk
Full sample
Loans/Dep. (+) 93.73 95.90 2.17 H 67.21 65.95 -1.26 L
Equity/TA (-) 10.37 11.72 1.35 L 12.94 13.51 0.57 L
Bonds/TA (-) 24.44 18.90 -5.54** H 26.17 25.99 -0.18 H
LongDep./Loans (-) 20.09 10.74 -9.35** H 64.32 63.29 -1.03 H
SpeDep./Loans (-) 24.63 33.93 9.30 L 24.19 30.06 5.87** L
LLP/Loans (+) 1.84 3.08 1.24** H 1.64 2.80 1.16** H
GL FX/TA (+) 0.10 0.27 0.18** H 0.00 -0.01 -0.01 L
BillsExc./Loans (+) 4.52 2.18 -2.33** L 1.62 0.81 -0.81** L
B.Loans/Loans (+) 5.29 4.29 -1.00** L 4.66 3.80 -0.86** L
(CapGL/T A)2 (-) 0.08 0.01 -0.08** H 0.09 0.02 -0.08** H
Large banks
Loans/Dep. (+) 92.98 104.72 11.74 H 86.88 101.29 14.41* H
Equity/TA N.S. 7.47 7.00 -0.48 8.52 13.42 4.90
Bonds/TA (-) 21.82 13.79 -8.03** H 22.26 16.07 -6.19** H
LongDep./Loans N.S. 10.78 2.86 -7.92** 19.87 10.34 -9.53**
SpeDep./Loans (-) 21.80 19.61 -2.19 H 23.20 21.86 -1.34 H
LLP/Loans N.S. 1.33 2.08 0.75** 1.42 3.70 2.29*
GL FX/TA N.S. 0.12 0.21 0.09** 0.02 -0.36 -0.38
BillsExc./Loans N.S. 2.14 0.90 -1.24** 4.06 2.28 -1.77
B.Loans/Loans N.S. 4.83 4.02 -0.82 4.29 2.96 -1.33**
(CapGL/T A)2 (+) 0.06 0.00 -0.05** L 0.07 0.06 -0.01** L
Small banks
Loans/Dep. (+) 94.02 93.12 -0.91 L 71.43 71.22 -0.21 L
Equity/TA (-) 11.50 13.18 1.68 L 11.34 11.66 0.33 L
Bonds/TA (-) 25.49 20.51 -4.98** H 26.34 26.16 -0.18 H
LongDep./Loans (-) 24.04 13.87 -10.17** H 44.86 25.41 -19.44** H
SpeDep./Loans (-) 25.81 38.93 13.12 L 26.47 35.10 8.63** L
LLP/Loans (+) 2.05 3.40 1.36** H 1.62 3.23 1.61** H
GL FX/TA N.S. 0.09 0.29 0.21** 0.00 0.02 0.02**
BillsExc./Loans (+) 5.53 2.66 -2.87* L 1.18 0.86 -0.32 H
B.Loans/Loans (+) 5.49 4.39 -1.10* L 4.82 4.06 -0.76 L
(CapGL/T A)2 N.S. 0.09 0.01 -0.08** 0.10 0.01 -0.09**
The table presents mean values of selected risk variables before and after the introduction of
deposit insurance (see Table 1.4 for definitions). Impact on P(distress) shows how an increase
in the variable influences the probability of bank distress (which is estimated in Table 1.4).
Diff. indicates the change from before to after deposit insurance and the symbols ** and *
denotes significance at 1% and 5% levels, respectively based on a simple t-test. Risk shows the
implication of the change in the variable, i.e. higher (H) or lower (L) risk. The period is from
1985-1990.
Table 1.8 on the facing page shows the results for the difference-in-difference analy-
sis. The variable of interest, P ost × Bank, is significantly negative for bonds to assets
for the full sample. This implies that the bond holdings of commercial banks are
significantly lower than for savings banks after the introduction of deposit insurance.
However, recall from Table 1.4 on page 21 that an increase in bonds decreases the
risk so commercial banks increased their risk relative to savings banks supporting the
hypothesis of moral hazard. The ratio of gains and losses on foreign currency to total
assets (GL F X/T A) is positive which also suggest at higher risk taking of commercial
banks relative to savings banks after the introduction of deposit insurance. The ratio
long deposits to total loans is significantly positive, thus the banks have increased their
holdings of this type of loans compared to savings banks, but an increase in this type
of loans decreases the risk of the bank, i.e. rejecting the hypothesis of moral hazard.
The decrease in LLP/Loans similarly implies a lower risk taking of commercial banks
relative to savings banks.
From a regulatory point of view, we are especially interested in testing if the

introduction of deposit insurance increases the systemic risk, and therefore we also
focus on the largest banks in the sample. For large systemic institutions, none of
the coefficients on the interaction term are significant and thus we reject that moral
hazard is an issue for these banks. The small institutions, where we have a better
match between the number of commercial and savings banks in the sample, we find
that the coefficient on P ost × Bank is negative and significant for the bond ratio and
positive for the ratio of gains and losses on foreign currency to total assets, which
suggest an increased risk for commercial banks relative to savings banks.
Post tests the difference between the risk before and after deposit insurance for
savings banks. We see that after controlling for bank size and macro economic con-
ditions, the savings banks increased their bonds to assets by 0.159. The difference
between the pre- and the post-period for commercial banks is captured by β1 + β3 ,
hence the commercial banks did not increase as much as savings banks (a total effect
Table 1.8: Difference-in-difference analysis of individual risk measures
2
Loans Equity Bonds LongDep. SpeDep. LLP GL F X BillsExc. B.Loans CapGL

Dep. TA TA Loans Loans Loans TA Loans Loans TA
Full sample
Post -0.150 -0.019 0.159*** 0.192*** 0.081 0.035*** 0.003 0.020 0.003 0.002***
Bank 0.168*** 0.023* 0.007 -0.112*** 0.011 0.005** 0.001*** 0.030*** 0.008 0.000
Post×Bank 0.026 -0.007 -0.055*** 0.059* 0.008 -0.005* 0.002** -0.018 -0.003 0.000
lnTA 0.019 -0.016*** -0.011*** -0.053*** -0.013* -0.001*** 0.000 -0.001 -0.002 0.000
Unemp -0.074 0.017 -0.002 -0.052*** 0.022 -0.002 -0.001 -0.007 -0.006 -0.001
NBRate 0.138** 0.001 -0.106*** -0.172*** 0.017 -0.006** 0.001 -0.007 -0.007 -0.002***
IntLong -0.085 -0.014 0.058*** 0.113*** 0.015 0.012*** 0.001 0.002 -0.001 0.001***
GDP -0.040** -0.004 0.028*** 0.046*** 0.003 0.001 0.001 0.006*** 0.001 0.001***
Constant 1.172*** 0.334 0.432*** 1.299*** -0.040 -0.043*** -0.012** 0.089** 0.166*** 0.001
Large banks
Post -0.266 -0.089 0.161*** 0.122*** 0.109*** 0.058*** 0.011 -0.006 -0.016 0.001
Bank 0.076 0.003 -0.002 -0.077* -0.012 0.001 0.001 -0.018 0.007 0.000
Post×Bank -0.033 -0.050 -0.008 0.031 -0.003 -0.012 0.005 0.006 0.004 -0.001
lnTA -0.022 -0.022** -0.004 -0.025*** -0.005 -0.003*** 0.002 -0.001 -0.003** -0.001
Unemp 0.018 0.061 -0.021* -0.030*** -0.009 -0.011* -0.006 -0.009* -0.001 0.001
NBRate 0.278*** 0.020 -0.143*** -0.095*** -0.073*** -0.011** -0.003 0.004 -0.001 -0.001***
IntLong -0.172* -0.050 0.076*** 0.077*** 0.056*** 0.017*** 0.006 -0.006 -0.004 0.001
GDP -0.066*** -0.013 0.038*** 0.032*** 0.016*** 0.002* 0.001 0.004*** -0.001 0.001*
Constant 1.228 0.400*** 0.499*** 0.549*** 0.237*** 0.028 -0.020 0.154*** 0.146*** 0.001
Small banks
Post -0.141 -0.003 0.157*** 0.243*** 0.051 0.025 0.001 0.023 0.008 0.002***
Bank 0.220*** 0.035* -0.009 -0.091*** -0.035 0.004*** 0.002*** 0.039** 0.007 -0.001
Post×Bank -0.003 -0.005 -0.048*** 0.036 0.057 -0.002 0.002* -0.024 -0.003 0.000
lnTA 0.003 -0.022*** 0.001 -0.073*** 0.019 0.001 -0.001 0.004 0.001 0.000
Unemp -0.077 0.010 -0.003 -0.061*** 0.025 0.001 -0.001 -0.005 -0.008 -0.001***
NBRate 0.143 0.003 -0.110*** -0.190*** 0.014 -0.005 0.002 -0.012 -0.009 -0.002***
IntLong -0.083 -0.009 0.060*** 0.127*** 0.011 0.010*** 0.001 0.004 0.001 0.001***
GDP -0.039* -0.003 0.027*** 0.051*** 0.002 0.000 0.001 0.006** 0.001 0.001***
Constant 1.311*** 0.385*** 0.313*** 1.582*** -0.375 -0.079*** -0.007* 0.014 0.157*** 0.001
The table shows the difference-in-difference analysis of the individual risk measures. Post is an indicator of 1 in the years after deposit insurance
is introduced, 0 otherwise, and Bank is an indicator of 1 for commercial banks, 0 otherwise. Post×Bank is the variable of interest, namely the
difference-in-difference estimate. The controls are log of assets, rate of unemployment, banks’ interest rate at the Danish National Bank, ten year
interest rate on government bonds and gross domestic product. The symbols ***, ** and * denotes significance at 1%, 5% and 10% level, respectively
based on robust standard errors clustered at bank level.
of 0.104 higher bond to asset ratio).
The coefficient on Bank shows the difference between commercial banks and sa-
vings banks in the pre-deposit insurance period. We find that commercial banks were
more risky than savings banks which is not that surprising considering the historical
difference between these two types of banks. Recall, that the difference-in-difference
approach shows the difference between commercial banks and savings banks after
controlling for these general differences between the two types of banks.
Based on the full sample, we find no consistent evidence of commercial banks
taking higher risk after the introduction of deposit insurance compared to savings
banks, hence we cannot reject our H0 hypothesis. The analysis on the small banks
separately provide some indication of higher risk taking for commercial banks relative
to savings banks, and next we therefore test the effect on the aggregate measure of
risk, the D-score.
Table 1.9: The effect of deposit insurance on D-scores
Full sample Large banks Small banks

Post 0.024 0.0648 0.016
(-1.41) (-1.04) (-0.96)
Bank 0.0209* 0.0271 0.0188
(-1.77) (-1.36) (-1.32)
Post×Bank -0.017 -0.0648 -0.0057
(-0.77) (-1.02) (-0.22)
Constant 0.0135*** 0.0098** 0.0144**
(-2.6) (-2.03) (-2.26)
The table provides results of the effect on the D-score, i.e. the aggregate mea-
sure of risk estimated in Equation 1.2. Post is an indicator of 1 in the years
after deposit insurance is introduced, i.e. from 1988, 0 otherwise, and Bank
is an indicator of 1 for all commercial banks, 0 otherwise. Post×Bank is the
variable of interest and shows the effect of introducing deposit insurance for
commercial banks relative to savings banks. T statistics are given in parenthe-
ses. The symbols ***, ** and * denotes significance at 1%, 5% and 10% level,
respectively based on robust standard errors clustered at bank level.
The difference-in-difference analysis based on the composite measure of risk, the

1.6. Controlling for Possible Endogeneity 33
D-score, is presented in Table 1.9. This analysis confirms that commercial banks did
not increase risk following the introduction of deposit insurance. Additionally, we find
no significant effect on the small banks separately.
1.6 Controlling for Possible Endogeneity
When deposit insurance was introduced in 1988, regulation made it possible for a
savings bank to convert to joint-stock ownership, i.e. to become a commercial bank.
This means that from this point in time, the status of the institution as either a
commercial bank or a savings bank is endogenous since the savings banks do not
chose to convert randomly. Unless the shareholders in a commercial bank are willing
to donate their shares to the bank, it is not possible for a commercial bank to convert
to a savings bank and still satisfy the capital requirements. Thus, the variable Bank
is only endogenous for savings banks. During the period 1988 to 1990, seven savings
banks converted to commercial banks.30
Although savings banks were allowed to convert to commercial banks, the guaran-
tors and depositors were not allowed to benefit from the transaction.31 A savings
bank could also convert to a commercial bank by being acquired by a commercial
bank. During the period 1989-1992 six savings banks were acquired by commercial
banks.
To address this endogeneity problem, we use a two stage least squares approach.
The estimation procedure is to treat the Bank variable as exogenous until 1988 and
endogenous for savings banks from 1988. Until 1988, savings banks had no incentive
to behave as commercial banks since they had no shareholders, thus Bank is treated
30
1989: SDS, Bikuben, Sparekassen Sønderjylland and Skive Sparekasse. 1990: Sparekassen
Fåborg, Sparekassen Nordjylland and Sparekassen Sydjylland.
31
The conversion had to be approved by the guarantors and/or the depositors. It is not clear how
these "bonds holders" were convinced to become shareholders unless they received a pay-off. We have
not been able to ascertain how this was done in practice but it seems that the guarantors received
10-15% overprice on their certificates.
as exogenous until 1988. We therefore apply two stage least squares from 1988. As
stated above, the commercial banks could not convert to savings banks, hence the
Bank variable is exogenous for commercial banks during the full period.
To perform the analysis, we need to identify appropriate instrumental variables
which are correlated with the decision to convert to a bank, but uncorrelated with the
explanatory variable in the main model, Risk. We use the existence of a foreign branch
in 1982, the growth in assets from 1981 to 1983 and the size in 1982. All instruments
are dated before the discussion started in the Savings Banks Association about the
possibility of converting, that is, before the political and the lobby process to change
the law even started.32 The existence of a foreign branch indicates that the savings
bank had a desire for growth and therefore a desire to become a bank. Similarly, the
savings banks with high growth and high levels of total assets in 1982 were likely to be
more interested in converting. Naturally, bank growth and size are likely to be highly
correlated with the explanatory variable Risk, but since the first stage regression is
estimated over the period 1988-1990, the correlation between bank growth and size in
1982 and Risk in 1988 is low. Given that the instrumental variables are dated before
the debate started, they are considered exogenous.
The first step regression is given as follows.
Bankit =β0 + β1 Branchi,1982 + β2 Growthi,1982 + β3 lnT Ai,1982 +

(1.8)
β4 Y 1989 + β5 Y 1990 + it
Where Bank is an indicator variable of 1 for those savings banks that converted
to a commercial bank after 1988, 0 otherwise,33 Branch is an indicator variable of 1
if the savings bank had a foreign branch in 1982, 0 otherwise, Growth is the average
yearly growth in total assets from 1981 to 1983 and lnTA is the logarithm of total
assets in 1982. Additionally, we have included year dummies for 1989 and 1990. The
32
According to Hansen (2001, p.271)) the idea arose sometimes in 1984 in the Association of
Savings Banks.
33
Recall that this sample only includes savings banks since commercial banks are not endogenous
as they cannot convert to savings banks.
1.6. Controlling for Possible Endogeneity 35
model is estimated as a probit model over the period 1988-1990, and we convert the
predicted probabilities from the model to binary variables at the median.
The results from the first stage regression are shown in Table 1.10. We find that
only the size of the savings bank in 1982 significantly explains the choice of converting
to a commercial bank after 1988.34
Table 1.10: First stage regression
Coefficient Std.Err T value

Branch82 0.429 (0.844) 0.51
Growth82 2.383 (4.087) 0.58
Size82 0.804*** (0.268) 3.00
Year89 11.013*** (1.358) 8.11
Year90 11.695*** (1.238) 9.45
Intercept -24.093*** (2.536) -9.50
McFadden R2 58.94%
For the second stage estimation, the indicator variable Bank is constructed in the
following fashion. If the institution is a commercial bank or the year is before 1988,
then the variable Bank is exogenous, hence the same as in the OLS model above (see
Equation 1.6 on page 26). The potential endogeneity arises after 1988 for savings
banks only because it is not random which savings banks that chose to convert to a
commercial bank. For savings banks we therefore replace the variable Bank with the
predicted values from the first stage regression. The interaction term P ost × Bank is
then calculated using the instrument for Bank, and Equation 1.6 is re-estimated using
OLS and clustered standard errors.
In Table 1.11 we see the results of the instrumental variable analysis. The table
only shows the difference-in-difference estimates (Post×Bank), and for ease of com-
parison the results from the OLS regression (from Table 1.8 on page 31) are also shown.
When controlling for endogeneity, we find similar results as in the base model, but the
34
We have not been able to come up with some other instruments that can explain the choice of
converting to a commercial bank, but since only seven banks chose to convert, this potential problem
of endogeneity may not be vital for our main findings of the paper.
Table 1.11: The effect on risk: difference-in-difference estimates

OLS 2SLS OLS 2SLS OLS 2SLS
Loans/Dep. 0.026 0.042 -0.033 0.035 -0.003 0.003
(-0.4) (-0.65) (-0.47) (-0.45) (-0.03) (-0.04)
Equity/TA -0.007 -0.008 -0.050 -0.073 -0.005 -0.006
(-0.62) (-0.71) (-1.02) (-1.2) (-0.52) (-0.55)
Bonds/TA -0.055 H -0.062 H -0.008 -0.027 -0.048 H -0.053 H
(-3.23) (-3.6) (-0.37) (-1.37) (-2.41) (-2.63)
LongDep./Loans 0.059 L 0.056 0.031 0.021 0.036 0.032
(-1.68) (-1.54) (-0.85) (-0.56) (-0.83) (-0.72)
SpeDep./Loans 0.008 0.002 -0.003 -0.014 0.057 0.055
(-0.1) (-0.02) (-0.17) (-0.89) (-0.49) (-0.47)
LLP/Loans -0.005 L -0.005 -0.012 -0.003 -0.002 -0.002
(-1.79) (-1.55) (-1.38) (-0.51) (-0.65) (-0.66)
GL FX/TA 0.002 H 0.002 H 0.005 0.007 0.002 N.S. 0.002 N.S.
(-2.13) (-2.22) (-0.96) (-1.13) (-1.84) (-1.84)
BillsExc./Loans -0.018 -0.018 0.006 0.004 -0.024 -0.024
(-1.55) (-1.57) (-0.58) (-0.37) (-1.48) (-1.48)
B.Loans/Loans -0.003 -0.004 0.004 0.005 -0.003 -0.004
(-0.55) (-0.67) (-0.53) (-0.74) (-0.48) (-0.57)
(CapGL/T A)2 0.000 0.000 0.000 -0.001 0.000 0.000
(-0.11) (-0.12) (-0.89) (-0.96) (-0.03) (-0.02)
This table presents the coefficients on the difference-in-difference estimate (Post×Bank) from
the second stage 2SLS regression together with the OLS results from Table 1.8. H/L (i.e.
higher/lower) shows the impact on risk for each risk measure (which is estimated in Table
1.4) that provides a statistically significant coefficient on a 10% level. N.S. indicates that the
measure was insignificant in Table 1.4. T statistics are given in parentheses based on robust
standard errors clustered at bank level.
ratios of long deposits and LLP to total loans are not statistically significant. Hence,
this analysis suggest that commercial banks did increase risk relative to savings banks
after the introduction, but these results should be interpreted with care because the
instruments are not very strong (see Table 1.10 on the preceding page).
The results of the analyses based on the aggregate measure of risk, the D-score,
confirms the main result that commercial banks did not increase risk relative to savings
banks after the introduction of deposit insurance (see Table 1.12). Hence, we find no
consistent evidence of risk shifting after the introduction of deposit insurance.
1.7. Robustness Check 37
Table 1.12: The effect of deposit insurance on the D-score

Post 0.024 0.0151 0.0648 0.0037 0.016 0.0166
(-1.41) (-1.01) (-1.04) (-0.62) (-0.96) (-0.96)
Bank 0.0209* 0.021* 0.0271 0.0273 0.0188 0.0189
(-1.77) (-1.77) (-1.36) (-1.38) (-1.32) (-1.31)
Post×Bank -0.017 -0.0084 -0.0648 -0.0044 -0.0057 -0.0064
(-0.77) (-0.41) (-1.02) (-0.29) (-0.22) (-0.25)
Constant 0.0135*** 0.0136*** 0.0098** 0.0095** 0.0144** 0.0146**
(-2.6) (-2.61) (-2.03) (-2.06) (-2.26) (-2.28)
The table provides the results of the effect on the D-score, i.e. the aggregate measure
of risk estimated in Equation 1.2. The table presents the results from the OLS re-
gression (from Table 1.9) and the second stage of the two stage least squares model.
Post is an indicator of 1 in the years after deposit insurance is introduced, i.e. from
1988, 0 otherwise, and Bank is an indicator of 1 for all commercial banks, 0 other-
wise. Post×Bank is the variable of interest, namely the effect of introducing deposit
insurance for commercial banks relative to savings banks. T statistics are given in
parentheses. The symbols ***, ** and * denotes significance at 1%, 5% and 10% level,
respectively based on robust standard errors clustered at bank level.
1.7 Robustness Check
The analyses have shown that commercial banks did not increase their risk relative to
savings banks after the introduction of deposit insurance despite the inherent moral
hazard in a deposit insurance scheme. Although a univariate analysis showed signifi-
cant changes, they do not present a clear picture of an increase in risk taking of com-
mercial banks. Additionally, the multivariate difference-in-difference model (Equation
1.6) also finds no consistent evidence of excessive risk taking after the introduction of
deposit insurance which is also the case when controlling for endogeneity.
Next, we wish to perform a test of robustness. Specifically, we test if corporate

customers in commercial banks have easier access to capital than customers in savings
banks in the Post period assuming that commercial banks would invest in high-risk
projects (i.e. increase lending) if they change their risk behaviour.
1.7.1 Lending to Corporate Customers
Signs of moral hazard could be seen in a change in lending because more risky banks
would invest more in risky projects and consequently the corporate customers would
obtain funding for new projects more easily. We therefore look at the capital structure
of the bank customers and expect that firms financed by commercial banks will increase
their debt (including both bank and non-bank borrowing) to equity ratio more than
corporate customers in savings banks. Such an increase indicates higher credit risk of
the bank, depending on collateral and priority of bank debt.
The data on Danish companies is a hand-collected sample from Greens handbooks
from 1983 to 1993.35 The data contains key variables from the financial statement:
revenue, earnings before and after tax, extra-ordinary items, total assets, debt, equity,
dividends and share capital. Additionally, the data includes the name of the bank
connection. This information makes it possible to test if there is a difference in the
leverage of firms having either a commercial bank or a savings bank before and after the
introduction of deposit insurance. Increased willingness to take risk would translate
into larger loans to customers.
Table 1.13: Number of firms based on bank connection
1986 1993
Commercial bank 771 775
Savings bank 58 54
Total 829 829
Multiple bank connections 166 71
The table shows the number of firms in the sample before
(1986) and after (1993) the introduction of deposit insur-
ance. It also includes the number of firms with multiple
bank relations.
As seen from Table 1.13, the number of firms having either a commercial bank
or a savings bank has not changed significantly during the period, probably due to
35
Since 1883 Greens handbooks have collected information on ownership structure, financial state-
ments and board members for Danish firms.
1.7. Robustness Check 39
relationship banking, resulting in a long-term relation. But the number of firms with
more than one bank relation has dropped significantly. This may be a result of the
number of acquisitions by financial institutions, making these larger and therefore
better capable of handling large customers alone.
Table 1.14: Descriptive statistics of firms based on the bank connection

Pre Post Pre Post
Variables Mean Median Mean Median Mean Median Mean Median
lnTA 11.24 11.03 11.55 11.42 10.91 10.65 11.16 10.96
Revenue/TA 1.98 1.71 1.75 1.52 1.97 1.74 2.04 1.86
ROA 0.05 0.04 0.03 0.03 0.03 0.04 0.03 0.03
Debt/Equity 4.31 2.24 3.84 2.20 4.89 2.61 6.30 2.40
Equity/TA 0.32 0.31 0.33 0.31 0.29 0.28 0.29 0.29
Profit Margin 0.05 0.04 0.04 0.03 0.04 0.03 0.04 0.02
EBT/TA 0.05 0.04 0.03 0.03 0.03 0.04 0.03 0.03
Debt/TA 0.67 0.69 0.67 0.69 0.70 0.72 0.71 0.71
lnDebt 10.8 10.59 11.10 10.95 10.53 10.29 10.79 10.52
ROE 1.73 0.56 1.51 0.42 1.09 0.40 0.48 0.32
Div Payout 0.58 0.35 0.92 0.44 0.73 0.35 1.05 0.72
The table provides mean and median values for the companies in the sample. The variables are
the logarithm of assets, revenue to assets, return on assets, debt to shareholder equity, equity to
assets, earnings before tax over revenue, earnings before tax over assets, debt to assets, return
on equity and dividends to earnings after tax.
Descriptive statistics of the firms in the sample can be seen in Table 1.14. Over-
all, the table shows little difference between the customers of commercial banks and
savings banks.
The research field of capital structure is enormous and factors found to effect
the capital structure of firms are numerous. Although research has identified a large
number of variables which potentially affects capital structure, there are relatively
few general determinants of capital structure (Harris and Raviv, 1991). Rajan and
Zingales (1995) test if variables known to affect the capital structure of American firms
also provide significant results when applied to international data. The variables they
find to effect capital structure are fixed to total assets, market to book values, size
(measured as log sales) and profitability (measured as EBITDA over book value of
total assets). The dependent variable is debt to book and market capital. Because
of limited data on firms, the variables used in this study are size, measured as the
logarithm of assets, growth in total assets and profitability as the ratio of P/L before
tax to total assets.
The empirical model is estimated with OLS using clustered standard errors and is
stated as follows.
D

=β0 + β1 P ostit + β2 Bankit + β3 P ostit × Bankit +
E it
β4 lnT Ait + β5 ROAit + β6 ∆T Ait + β7 N BRatet + (1.9)

D

β8 U nempt + β9 IntLongt + β10 GDPt + β11 + it
E it−1
Size is in general positively related to leverage, which may be explained by lower in-
formation asymmetry of larger compared to smaller firms (Rajan and Zingales, 1995).
Although size is found to be correlated with leverage, there is no clear understanding
of why this is the case. Profitability and growth are expected to be negatively related
to leverage. The lagged debt to equity ratio (β11 ) comes from a partial adjustment
model which states that the level of debt in year t is dependent on the level of debt
in year t-1 and measures the speed of adjustment satisfying 0 < β11 < 1.
We test the capital structure of corporate customers in commercial banks ver-
sus savings banks by focusing on the difference-in-difference estimator, β3 , which is
expected to be zero.
Table 1.15 on the next page presents the results of the analysis of firms’ capital
structure for both the OLS regression and two stage least squares. We see that the
debt to equity ratio of corporate customers in commercial banks is not significantly
different than for customers in savings banks after the introduction of deposit insu-
rance, (P ost × Bank). Since commercial banks do not increase lending to corporate
customers compared to savings banks, this analysis supports the H0 hypothesis, i.e.
that commercial banks did not change behaviour as a consequence of the introduction
1.8. Conclusion 41
of deposit insurance.
Table 1.15: Lending to corporate customers

Post -1.475 -3.141** -1.375 -3.153** -3.372* -3.372*
(-1.33) (-2.15) (-1.12) (-2.05) (-1.65) (-1.65)
Bank 0.199 0.206 0.171 0.180 1.189 1.189
(0.38) (0.39) (0.31) (0.32) (1.32) (1.32)
Post×Bank -1.377 0.491 -1.458 0.525 -1.109 -1.109
(-0.78) (0.87) (-0.75) (0.85) (-0.88) (-0.88)
lnTA -0.066 -0.077 -0.077* -0.090 0.346** 0.346**
(-0.9) (-1) (-1.09) (-1.18) (2.03) (2.03)
ROA -19.381*** -19.488*** -19.132*** -19.250*** -21.148** -21.148**
(-5.44) (-5.43) (-5.24) (-5.24) (-2.44) (-2.44)
∆TA 2.426*** 2.421*** 2.705*** 2.700*** -5.501 -5.501
(3.48) (3.47) (3.93) (3.92) (-1) (-1)
NBRate -0.041 -0.072 -0.241 -0.261 2.555* 2.555*
(-0.09) (-0.16) (-0.45) (-0.49) (1.86) (1.86)
Unemp 0.946* 0.904 1.055* 1.013* -0.648 -0.648
(1.66) (1.58) (1.77) (1.67) (-0.52) (-0.52)
IntLong -0.779 -0.744 -0.807 -0.773 -1.135 -1.135
(-1.4) (-1.33) (-1.38) (-1.3) (-1.4) (-1.4)
GDP -0.380** -0.371** -0.366** -0.357** -0.754** -0.754**
(-2.48) (-2.4) (-2.29) (-2.19) (-2.15) (-2.15)
D/Et-1 0.667*** 0.668*** 0.671*** 0.672*** 0.665*** 0.665***
(8.53) (8.76) (8.01) (8.26) (5.15) (5.15)
Constant 4.926 5.195 5.817 6.027 0.095 0.095
(1.2) (1.23) (1.21) (1.24) (0.02) (0.02)
The table provides the results of lending to corporate customers. The table presents the
results from the OLS regression and the second stage of the two stage least squares model.
Post is an indicator of 1 in the years after deposit insurance is introduced, i.e. from 1988, 0
otherwise, and Bank is an indicator of 1 for all commercial banks, 0 otherwise. Post×Bank
is the variable of interest, namely the effect of introducing deposit insurance for commercial
banks relative to savings banks. T statistics are given in parentheses. The symbols ***, **
and * denotes significance at 1%, 5% and 10% level, respectively based on robust standard
errors clustered at firm level.
1.8 Conclusion
During the 1980s, Denmark operated a regulatory system with high capital require-
ments and a firm closure policy of banks in distress. Formal deposit insurance was
introduced in 1988 in the form of a fixed rate system with a limit on the amount
insured which gave rise to risk shifting. We analyse whether the strong regulatory
environment can curtail the moral hazard problems embedded in a fixed rate deposit
system. Denmark offers a unique opportunity for testing the risk shifting hypothe-
sis because commercial banks have incentive to perform risk shifting whereas savings
banks have not. We show that commercial banks did not increase their risk relative to
savings banks in response to the introduction of the formal deposit insurance scheme.
The large banks in our sample represent the systemic banks and they are, of course,
interesting from a regulatory point of view. We find that the large institutions did
not increase risk either, suggesting that systemic risk is not jeopardised when deposit
insurance is introduced into a system with high capital requirements and a firm closure
policy. These results should be of particular interest to regulators when promoting
the introduction of deposit insurance across counties.
Chapter 2
Bank Lending and Firm Performance:

How do Bank Mergers affect Small Firms?
Bank Lending and Firm Performance:
How do Bank Mergers affect Small Firms?
Lene Gilje Justesen

Aarhus University
Denmark
Abstract
This paper analyses credit rationing of firms following bank mergers, and its
possible long-term implications. Bank mergers are expected to influence small
firms more than large firms as small firms rely more on bank financing, hence
they are more vulnerable to bank shocks.
Using a large Danish dataset, I measure the impact of bank mergers on
small corporate borrowers on two dimensions: the level of bank debt and the
operating performance. I find that bank mergers have no effect on bank debt
but surprisingly, the implicated firms have significantly higher performance after
the bank merger than comparable firms, suggesting increased efficiency of the
new consolidated bank. However, analyses suggest that if the acquiring bank
is very large or if the merger takes place in the firm’s local area, the effect
on corporate customers is negative. This paper adds to existing literature by
empirically examining how bank mergers affect small corporate borrowers and I
find no evidence that such an event is harmful and it may, in fact, be beneficial
for the implicated firms if the merger is not large or local.
Keywords: Bank mergers, SME financing, firm performance.
JEL Classification: G21, G32, M42.
This paper has received many helpful comments and feedback, and in particular I would
like to thank Jan Bartholdy, Ken L. Bechmann, Hans Degryse, Marie Herly, Vasso Ioan-
nidou, Steven Ongena, David Sloth Pedersen, Frank Thinggaard, Jeffrey Wooldridge, and
the participants of the FRG Annual Research Workshop 2013, and the accounting seminar
participants at Aarhus University, School of Business and Social Sciences.
45
46 Chapter 2. Bank Lending and Firm Performance
2.1 Introduction
Micro, small, and medium size firms (hereafter SMEs) are the key components of the
European economy,1 and numerous studies also show that small firms are financially
more restricted than large firms and use bank loans as the primary source of exter-
nal financing (Petersen and Rajan, 1994; Wagenvoort, 2003; Kim et al., 2011). The
increasing number of bank mergers and acquisitions across countries adds another di-
mension to the SME financing literature because such an event disrupts the bank-firm
relationship.2 Therefore, it is important and interesting to know more about if and
how these firms are affected when banks are consolidating. There are three possible
explanations why especially small firms could be harmed by bank mergers. First, the
size effect; prior literature shows that small firms borrow mostly from small banks
(Berger et al., 2001, 2005) and therefore it might have consequences for the small cor-
porate customers when banks grow through mergers. Second, the increase in market
power; as banks consolidate they may also increase market power which might result
in increasing interest rates for the corporate customers (Hannan, 1991). For small
informationally opaque firms that cannot change bank easily, this may translate into
a hold-up problem.3 Third, the loss of soft information; a disruption in the bank-
firm relationship during bank restructuring after the merger may result in loss of soft
information and affect small bank-dependent firms.
This paper demonstrates how firms that are customers in target banks are affected
by bank mergers. First, I test the level of bank debt and total debt for firms expe-
riencing a merger between their bank and another bank. Second, I test if the bank
merger influences the operating performance of implicated firms.
1
SMEs cover 99.8 percent of enterprises and provide employment for 66.9 percent of the work-force
in the 27 EU countries. These numbers are estimates for 2010, (European Commission, 2011).
2
I do not differentiate between mergers and acquisitions in the analyses because of unknown
validity of this information (see Appendix A.3 on page 122 for further detail.)
3
The hold-up problem considers the bank-firm relation to be a monopoly situation where the
bank has proprietary information about the firm and therefore is able to extract rents by demanding
a higher interest rate (Boot, 2000).
2.1. Introduction 47
The empirical analyses find no significant effect on firms’ bank debt in neither
the short- nor long term samples. Surprisingly, the operating performance increases
significantly after a bank merger which might suggest that bank mergers result in
efficiency gains that are beneficial for the corporate customers, maybe as a result of
an increased monitoring of these firms. We know from prior literature that contrary
to public debt, banks have the advantage of being able to adjust contract terms and
interest rates through monitoring over time (Berger and Udell, 1995a) and prevent
opportunistic behaviour (Mayer, 1988; Holmstrom and Tirole, 1997). The finding
of this paper suggests that the new merged bank is more capable of performing this
task, resulting in higher firm performance. When focusing on subsamples, the analyses
show that the total level of debt increases significantly for those corporate customers
where the acquiring bank is a Big 5 bank,4 whereas there is a negative effect on bank
debt for firms that are located close to either the acquiring or target bank. This
suggests that large mergers cause a shift from bank loans to other types of lending,
for example mortgage loans and analyses also find an increase in trade credit for these
firms specifically.5 In addition, local mergers are disadvantageous for the corporate
customers which suggest that the banks increase market power after the merger. Based
on the analyses, I cannot document a negative effect on corporate customers that are
subject to bank mergers as these firms in fact have higher operating performance than
comparable firms after a bank merger. There is, however, some evidence to suggest
that both mergers with a Big 5 acquirer and local mergers are harmful for corporate
borrowers.
There are two issues that are addressed specifically in this study. First, a main
concern when estimating bank credit is whether this is driven by a demand of the firm
or by the supply of the bank. To address this issue, I use a matched sample approach
that matches any firm exposed to a bank merger with a comparable firm with no
4
The five largest banks are Danske Bank, Nordea, Jyske Bank, Sydbank and Nykredit Bank.
5
Prior research find trade credit to substitute for bank debt in economic downturn (Peterson and
Rajan, 1997; Wilner, 2000), hence firms may turn to this alternative if they are in lack of financing.
exposure to bank mergers. If these firms have similar trends in bank debt in the pre-
merger period, it is reasonable to assume that they also have the same demand for
bank debt in the post-merger period (see Section 2.3.1 about the matching approach).
This setting makes it possible to analyse if bank mergers cause a shift in bank debt for
the implicated firms relative to the control group. Second, there might be an issue of
endogeneity. For each individual firm, a bank merger is treated as an exogenous shock
as it takes place independently from the operations of that specific firm. However,
bank mergers may be a result of all the customers in a bank being poor performers,
implying that the bank merger is an endogenous event.6 This concern is addressed
with the use of bank fixed effects which controls for any permanent differences between
banks.
A few papers have studied how corporate customers are affected by bank mergers
using data from a credit register from either Italy (Bonaccorsi di Patti and Gobbi,
2007; Sapienza, 2002; Panetta et al., 2009) or Belgium (Degryse et al., 2011). The
present study adds to this literature in several ways. First, the data used makes it
possible to track the performance of firms after the merger even if there is no debt
contract (i.e. firms do not drop out of the sample if bank credit is not extended).
Additionally, the Danish economy is mainly composed of small and unlisted firms,
and most of these only have a single bank relationship.7 They are interesting because
they are more bank dependent, so if bank mergers are harmful, I am most likely to
detect it in this market. Also, Denmark provides a good setting for testing the effect
of bank mergers on firm credit availability due to the numerous mergers in the period,
not only during the crisis period.8
6
Unreported results show that firms with ROA above average are more likely to be subjected to
bank mergers. Consequently, bank mergers are not caused by poorly performing customers but more
likely by inefficient bank management or lack of diversification.
7
Large firms and listed firms are excluded from the analyses (see Table 2.1) because these firms
have easier access to external financing other than bank loans. Only 6.54% of the firms in the final
sample have multiple banks.
8
All analyses have been performed excluding the crisis period, i.e. years 2008-2010, and the
results of the paper are not driven by this specific period.
2.2. Prior Literature and Hypotheses Development 49
This paper differs from existing literature by focusing on small, bank dependent
firms and following their long run operations with the use of a difference-in-difference
methodology. In this setting, I take advantage of the direct link between the firm and
its bank connection.
The rest of the paper is organised as follows. Section 2.2 provides a literature
overview and hypotheses development. Then follows Section 2.3 with an overview of
the data, descriptive statistics, and the matching specifications. Section 2.4 presents
the methodology and Section 2.5 shows the results of the analyses. Finally, I conclude
in Section 2.6.
2.2 Prior Literature and Hypotheses

Development
There are three possible explanations why bank mergers may be harmful for small
corporate customers. First, the size effect of bank mergers shows that as banks grow
they place less emphasis on small business lending. The most common finding is that
a merger between a large and a small bank tends to reduce small business lending
whereas a merger of two small banks tends to increase small business lending (see
Berger et al. (1999) for a literature overview). The reason is that large banks can
offer other customer services9 and may shift focus away from small businesses because
such lending is scope inefficient. Small business lending is often based on private
information gathered over time by personal involvement with the firm’s owner to
obtain knowledge of the business and the local market it operates in. Such small
business lending may be too costly and disadvantageous for large banks because it
requires implementation of quite different procedures and because soft information
is more difficult to transmit within large banks that also often have limited local
9
This could include, for example, underwriting, risk management services and derivative con-
tracts.
knowledge (Berger et al., 2001). Also, prior evidence suggests that when firms are
forced to borrow from large banks, they are more credit constrained than those that
can choose a small bank (Berger et al., 2005)
Second, a result of bank mergers may also be that the new consolidated bank
gains higher market power and consequently offers less favourable prices to small
corporate borrowers to increase profits. For example, Hannan (1991) finds banks
operating in more concentrated local markets charging higher interest rates on loans.
This is essential for especially small businesses because these firms tend to choose
local banks (Kwast, 1999) and if their relation with the bank primarily builds on soft
information, the bank’s informational monopoly may prevent the firm from changing
bank.10 Similarly, DeGryse and Ongena (2005) find that interest rates increase as
the distance to competing banks increases. Hence, if the nearest competing bank is
far away from the customer, the current bank charges higher interest rates on small
business loans. DeYoung et al. (2008) find the probability of loan default to increase
with distance and competition in the local market although this effect decreases over
time suggesting that banks improve their ability to lend to small businesses. Related
to this, Petersen and Rajan (1995) argue that lenders in concentrated (uncompetitive)
markets are more likely to form strong relations with their small corporate customers
and reduce loan default rates through careful monitoring, but the indirect effect of
such focus on current customers may be a reduced overall loan supply as the banks
may tend to deny loans to new good applicants. Studying bank mergers specifically,
Sapienza (2002) finds efficiency gains (resulting in lower interest rates on loans for
corporate customers) from in-market mergers unless such mergers result in monopoly
power to the bank.
Third, since bank mergers in general are followed by an organisational restructuring
10
Since it takes time to build up a relation with a new bank, a bank change may not be beneficial
for small firms. This contrasts empirical evidence on large, listed firms showing that firms change
bank because they are offered a lower interest rate on loans but the rate will increase with the
duration of the bank-firm relation so eventually, the firm will change bank again (Ioannidou and
Ongena, 2010).
2.2. Prior Literature and Hypotheses Development 51
especially for the target bank, this disrupts the bank-firm relationship and results in
a loss of information. The risk of the borrowers in the target bank will be reassessed
and different standards to loan approval might apply. In this process of evaluating
the customers, banks may also perform balance sheet cleaning resulting in termination
of the least profitable firms and/or firms that rely on soft information lending. Also,
bank mergers may indeed be harmful for especially small corporate customers because
a bank-firm relation is more important for small firms and strong relations are found
to increase firm value (Boot, 2000).
However, the arguments that small businesses are affected by bank mergers are
based on the assumption that small business lending is based primarily on soft infor-
mation. If the firm, however, has strong financial statements and valuable collateral,
small corporate customers would have a transaction-based relation and receive the
same services as large firms. For example, recent literature argues that large banks
can successfully provide other types of lending technologies targeted at small and
more informationally opaque firms, e.g. small business credit rating, asset-based len-
ding, factoring, leasing, and fixed-asset lending (Berger and Udell, 2006; De la Torre
et al., 2010; Beck et al., 2011). Therefore, bank mergers are more likely to influence
those firms that base their relation with the bank on soft information as opposed to
transaction-based lending.
But a bank merger may even be beneficial for small customers as larger banks can
more easily diversify than small, unaffiliated banks. For example, Hancock and Wilcox
(1998) show that in times of financial distress, small and undiversified banks reduce
lending to small businesses more than large and diversified banks. If the bank merger
is a result of poor management of the target bank, then a more efficient manager may
increase lending to small corporate borrowers because a more efficient bank is also
able to serve more customers efficiently (Berger et al., 1999).
Comparable European studies that analyse how SMEs are affected by bank merger
activities are limited to Italy (Bonaccorsi di Patti and Gobbi, 2007; Sapienza, 2002;
Panetta et al., 2009) and Belgium (Degryse et al., 2011), but the results are mixed.
Sapienza (2002) finds in-market mergers to have a positive effect for borrowing firms
in terms of lower interest rates, hence there are efficiency gains from bank mergers
within the same geographical area.11 Additionally, Sapienza (2002) finds evidence
that independently of other firm characteristics, small firms are being dropped when
the bank grows, i.e. supporting the literature on large banks having larger customers
(Berger et al., 2001, 2005). Bonaccorsi di Patti and Gobbi (2007) find the effect of
bank mergers on the credit availability for small firms to be slightly negative, but
this is offset after three years. Degryse et al. (2011) differentiate discontinuing firms
based on whether the firm switches bank or is dropped by the bank. According to
their findings, borrowing firms are affected in their profitability when banks merge,
but firms with multiple bank relations are less harmed by bank mergers as they can
hedge against bank discontinuity. Their study, however, only includes eight in-market
mergers. Although these studies find somewhat mixed results, one obvious caveat is
the use of relatively large firms and firms with multiple bank relations. In a Spanish
study by Hernández-Cánovas and Martínez-Solano (2007), firms with only one or two
banks are found to experience more credit rationing than firms with several banks,
and Degryse et al. (2011) find that firms with single bank relations are more affected
by bank mergers than firms with multiple banks.
This study adds to the existing literature by analysing a sample of small and
primarily single bank relationship firms, i.e. the firms that are presumed to have
the highest risk of being affected by bank merger activities. This leads to the first
hypothesis.
Hypothesis 1: Bank mergers have a negative effect on bank debt for corporate
customers.
In contrast to most existing literature, this study is able to track all firms in the
11
However, this is not the case if the merger gives monopoly power to the bank.
2.3. Data and Key Explanatory Variables 53
years following a bank merger. This provides a unique opportunity to test the impact
of bank mergers on corporate customers compared to firms that are not subject to
bank changes. If bank mergers reduce credit availability then, through this channel,
the operating performance of implicated corporate customers is expected to be lower
than the performance of comparable firms. To my knowledge, only two prior studies
have analysed the performance of corporate customers following bank mergers. First,
Bonaccorsi di Patti and Gobbi (2007) do not find bank mergers to have long-run effects
on firm’s borrowing, but they only track the performance of firms that remain in the
credit register after bank mergers, hence their study suffers from survivorship bias.
Second, Degryse et al. (2011) find lower operating performance of the firms that are
dropped by the bank versus those firms that either switch or stay. Contrary to their
study, I use control firms that are not exposed to bank changes to successfully portray
how the performance of the firm would have been without the bank merger event.
This leads to the following hypothesis.
Hypothesis 2: Bank mergers have a negative effect on operating performance for

corporate customers.
2.3 Data and Key Explanatory Variables
The data stems from two different sources. Firm data is from the Experian database
and bank information is from the Danish Financial Supervisory Authority.
At firm level, the data includes information from financial statements, ownership
data, industry classification, type and status of the firm, auditor, and the name of
the bank(s) that the firm uses. The information about each firm’s bank connection
either stems from the financial statements or alternatively, Experian has collected it
manually by contacting the firm directly. This information is, however, not available
for all Danish SMEs. The number of firms with available bank information is 188,411
while only approximately 94,000 of these firms also have available information from
financial statements (a total of 889,488 firm-year observations).12
Table 2.1: Sample selection
Selection criteria Firm year obs.

Information from financial statements and bank connection 889,488
Less 128,736 obs. of financial institutions 760,752
Less 2,061 obs. of utility firms 758,691
Less 13,314 non private limited firms 745,377
Less 2,320 obs. with missing total assets 743,057
Less 2,105 obs. with unequal assets and liabilities 740,952
Less 1,768 obs. with suspected errors* 739,184
Less 7,468 duplicate obs. in specific years 731,716
Less 9 obs. containing 0 number of months 731,707
Less 1,920 obs. in foreign currency 729,787
Less 29,731 parent or daughter obs. plus 2,033 new obs. 702,089
Less 1,297 obs. of listed firms 700,792
Less 23,866 obs. of large firms (>EUR 16m/19m)** 676,926
Less 102,106 obs. of small firms (<EUR 100.000) 574,820
Final sample containing financial statements (See Panel A, Table 2.3) 574,820
Treatment firms (5,902 firms subject to a bank merger) 55,618
Control group (63,966 firms with no bank change) 440,556
Matched sample (9,568 firms. See Panel D, Table 2.3) 88,443
The table shows the sampling criteria. The primary information of interest is the
name of the bank connection(s) combined with the financial statements. * Errors are
considered as negative values in net sales, fixed assets, intangible assets, PPE, financial
assets, current assets, inventories, and trade debtors. ** According to Danish GAAP,
the classification of large firms changed in 2009 from approximately EUR 16m to EUR
19m in total assets.
Table 2.1 shows how the final sample is created based on the information on the
bank connection(s) and the financial statements.13 Financial institutions, utility firms
and non private limited firms that are not required to report after Danish GAAP are
left out. Observations with missing total assets, unequal sums of total assets and total
liabilities, suspected errors in the financial statements (or in the database), duplicate
12
The data is an unbalanced panel which raises the concern of possible selection bias. It is likely
that the missing years of observations primarily stem from small firms with poor performance. If
that is the case, the results are biased in a positive direction, meaning that the results would be
negatively affected without this possible selection bias. I test for sample selection specifically (see
Section 2.3.1).
13
See Appendix A on page 109 for a detailed data overview.
firm-year observations, observations containing 0 number of months and statements in

foreign currencies are also deleted. When firms are part of a group enterprise, a special
sorting algorithm is created that focuses on consolidated statements because this is
more important for banks when evaluating customers than unconsolidated statements
(see Appendix A). Public and large firms are outside the scope of this study because
they are not as bank dependent as the SMEs. Lastly, firms with less than €100,000
in total assets are deleted. This results in a final sample containing 574,820 firm-year
observations. In this sample, there are 5,902 firms (55,618 firm-year observations)
that are customers in target banks, i.e. treatment firms. There are 63,966 firms
that are suitable as control firms (i.e. those without any bank changes) hence from
this sample, one specific match is found for each treatment firm (see Section 2.3.1 on
the matching approach). After the matching, the final sample consists of 5,968 firms
(88,443 observations) where half of these are treatment firms and the other half are
controls.
Through mergers and bank failures, the number of Danish banks has decreased
from 190 in 2000 to 136 in 2010.14 During the recent financial crisis, some banks
were acquired by the government-owned winding-up company, the Financial Stability
Company, while many other banks were acquired or merged.15 In the sample there
are a total of 56 bank mergers and eight bank failures between 2001 and 2011.16 A
merger is a merger between two banks where one bank is stronger than the other
assuming that the credit policy of the strong bank dominates, hence only customers
of the target (the weak) bank are treatment firms. If two banks consolidate into a
new bank, and there is no indication that one bank is stronger than the other, then
14
These are commercial banks, savings banks and cooperative banks, and I do not differentiate
between them in the analyses.
15
The Financial Stability Company was established in October 2008 in agreement between the
government and the Danish financial sector. The company handles the liquidation or reconstruction
of failing banks. Banks that are acquired by the Financial Stability Company are considered bankrupt
and are not included in the sample of analysis.
16
This is not the total number of mergers in Denmark during this period, but only bank mergers
with available financial statements of corporate customers are included.
corporate customers of both banks are considered to be exposed to a bank merger.17
Table 2.2: Bank mergers and bank changes
Number of: Bank changes caused by:
Year Bank Bank Bank Bank

mergers bankruptcies merger bankruptcy
2001 4 3,090a
2002 5 927b
2003 3 218
2004 1 6
2005 7 46
2006 8 53
2007 6 81
2008 7 2 39 272
2009 5 2 409 726
2010 7 1 954c 0
2011 3 3 96 116
The table shows the number of bank mergers and bank-
ruptcies in the sample from 2001 to 2011. Additionally, the
table presents the number of firms’ bank changes in each
year divided into those related to bank mergers and bank
bankruptcies, respectively. a) Most changes are caused by
the merger between BG Bank and Danske Bank. b) In
2002 Midtbank and Handelsbanken merged. c) The high
number is caused by the merger between Nykredit and
Forstædernes Bank.
From Table 2.2, we see that a total of 5,919 firms are exposed to a bank merger.
This number is higher than the number presented in Table 2.1 (5,902) which is caused
by 17 firms being exposed to a second bank merger during the sample period. Only the
first merger for each firm is considered in the analyses. The number of firms subject
to a bank merger is very high in 2001. This is due to a merger between two large
banks, BG Bank merged with Danske Bank.18 The majority of the firms stay in the
new bank after a bank merger. From Table 2.2, we also see that one bank is failing
in 2010 but this does not lead to any bank changes in the sample firms. The failing
17
See Appendix A.3 for further details.
18
Since this single merger might drive the results, the analyses are also carried out without this
merger. This does not change results substantially.
bank is Eik Banki, but no firm in the sample is still customer in the bank after 2008,
hence no firm is affected by the bankruptcy in 2010.
Table 2.3: Summary statistics for firms
Mean Median Std.Dev. No Obs.

Panel A: Full sample
Assets Total assets in Th. EUR 1,645 642 2,603 574,820
ROA Net income over assets 0.030 0.037 0.216 574,416
BC Bank debt over total assetsa 0.378 0.318 0.319 573,928
Fixed Fixed assets over total assets 0.404 0.337 0.319 555,873
Cash Cash over total assets 0.137 0.043 0.200 532,378
Growth Yearly change in sales 0.166 0.015 0.976 407,588
Emp Number of employees 17.06 7 49.06 359,183
Age Age of the firm in years 12.44 10 10.54 555,376
Panel B: Firms exposed to bank mergers
Panel C: The matched sample
The table provides descriptive statistics for the full sample, all firms that are
subject to a bank M&A and the matched sample. The statistics are based on all
available firm-year observations of the sample. See Table 2.1 for sample selection.
The data is winsorized at 1st and 99th percentiles. a) Bank debt is defined as
short term debt less trade payables.
Table 2.3 shows the descriptive statistics of the full sample of firms that are suitable
for analysis (i.e. after the sorting process. See Table 2.1). From this sample I identify
treatment firms and find a suitable match for each treatment firm. Table 2.3 shows
that the average firm exposed to a bank merger is smaller than the full sample in
terms of total assets, however, not in terms of number of employees. They have higher
performance measured as ROA and the level of bank debt to total assets is also higher
than for the full sample whereas they have less collateral (fixed to total assets) and a
lower growth rate.
Panel C in Table 2.3 on the previous page provides descriptive statistics of the
sample of analysis, i.e. the matched sample. Overall, the descriptive statistics show
that this sample consists primarily of very small firms (measured as total assets and
number of employees). This sample does not seem to be very different from the full
sample in terms of the level of bank debt and cash to total assets. However, the firms
differ from the full sample not only as regards size, but also as regards profitability
which surprisingly is higher than for the full sample whereas the yearly growth rate
in sales is lower.
Table 2.4: Summary statistics for banks
Mean Median Std.Dev. No obs

All banks
Assets Total assets in Th EUR 4,727,890 197,753 27,461,264 1,049
ROA Net income to total assets 0.008 0.009 0.010 1,049
OpeCost Operating cost to total assets 0.031 0.032 0.010 1,049
BadLoans Non performing loans to total loans 0.011 0.008 0.013 1,048
Target banks (year before merger)
Assets Total assets in Th EUR 1,185,818*** 125,697** 4,257,650 30
ROA Net income to total assets 0.001** 0.007* 0.017 30
OpeCost Operating cost to total assets 0.033 0.033 0.008 30
BadLoans Non performing loans to total loans 0.023*** 0.013*** 0.022 30
Acquiring banks (year before acquisition)
Assets Total assets in Th EUR 6,884,377 669,225*** 19,431,953 36
ROA Net income to total assets 0.007 0.009 0.011 36
OpeCost Operating cost to total assets 0.027** 0.026** 0.009 36
BadLoans Non performing loans to total loans 0.013 0.007 0.016 36
The table provides descriptive statistics for the full sample of banks, target banks and acquiring
banks. The statistics of the full sample are based on all available bank-year observations and
only the year before the merger is included for target and acquiring banks. The symbols *,
** and *** denote significance at 1%, 5% and 10% levels on mean (simple t-test) and median
(wilcoxon test) differences between target or acquiring banks relative to the full sample. The
data is winsorized at 1st and 99th percentiles.
As regards target banks compared to the full sample of banks, Table 2.4 on the
facing page shows that target banks are significantly smaller, they have lower perfor-
mance and a higher level of non performing loans to total assets in the year before the
merger. Acquiring banks, on the other hand, are larger and more efficient (operating
cost to total assets) than the full sample. The descriptive statistics of the banks in
the sample are very much in line with European studies showing that target banks in
general are smaller, less profitable and less efficient than acquiring banks (Rhoades,
1998; Focarelli et al., 2002; Altunbaş and Marqués, 2008).
2.3.1 Matched Sample
Each individual firm that has changed bank because of a bank merger during the
sample period is matched with a comparable firm without any bank changes (there
are 63,966 firms and 440,556 firm-year observations that are suitable as controls).
The matching approach is based on a nearest neighbour matching with replacement
within a specified calliper width to avoid poor controls (Caliendo and Kopeinig, 2008).
This means that a specific control firm can act as control for several treatment firms
and since a calliper width is specified, not all treatment firms find suitable controls
and hence they drop out of the sample. The matching is based on propensity scores
modelling the probability of being a treatment firm as a function of firm performance
(ROA) and short term debt less trade payables to total assets (BC). Specifically, the
matching is the closest match based on the year of the merger (yeart ), propensity scores
in yeart , industry and the mean total assets in yeart-1 and yeart-2 .19 This results in a
matched sample consisting of 4,784 treatment firms and naturally the same amount
of control firms which gives a total of 88,443 firm-year observations.20 Based on this
19
The bank information from 2000 and therefore only bank mergers from 2001 and onwards are
included in the analysis, but information from financial statements is available in 1999 which is why
the means of the two years prior to the bank merger are included in the matching criteria.
20
As shown in Table 2.1 on page 54, a total of 5,902 firms are exposed to a bank merger but for
1,118 treatment firms there are no suitable control firm and therefore they drop out of the sample.
matched sample, two sub-samples are constructed including only one or five years
before and after the bank merger event in order to analyse short and long-term effects
on corporate customers. There are 17 firms that experience two bank mergers during
the sample period, however, only the first event is considered in the analyses.
The validity of the sample is tested using three different tests.21 First, the difference
in bank debt between the treatment firms and the control firms is tested in the pre-
event period where indicator variables for treatment firms have been constructed in
each year prior to the merger. If these indicator variables are significant in the full
model, it would indicate that there is a significant difference in the pre-event period.
None of these indicator variables turn out significant, suggesting that there is no
significant difference between the treatment firms and the control group in each specific
year in the pre-event period. Second, to make sure that the effect is caused by the
bank merger and not by some alternative force, I perform a placebo test where I
assume that the event occurs two years before the actual date.22 This test provides
results for the difference-in-difference estimator that are indistinguishable from zero,
hence assuming the event occurs at some other time does not alter the results. Third,
a test for sample selection is performed where I generate a dummy variable which is
set to 1 if the lagged values are missing. If this indicator of missing values turns out
significant in the full model, this could indicate a selection problem. This test provides
insignificant results for the five year sample, hence there is no reason to believe that
the imbalance of the data is caused by selection.
21
Several matched samples are constructed based on mean values of total assets, bank debt and
ROA, industry and year. In addition, I construct several models of propensity scores and also use
another control sample that excludes corporate customers in acquiring banks. None of these samples
performs as strong in the three tests of validity as the sample used in the paper and they are therefore
not presented.
22
As suggested by Roberts and Whited (2011).
2.4. Methodology 61
2.4 Methodology
This study applies a difference-in-difference approach where firms that are exposed
to a bank merger are compared with similar firms that are not exposed to a bank
merger and it therefore successfully portrays how the situation would have been for
the treatment firms without this bank merger event. Using a matched sample will
control for the demand effect since the demands for bank debt of these two firms are
assumed alike, conditional on a suitable match. Therefore the supply effect, i.e. credit
availability in a situation of bank mergers, is isolated in the analyses.
2.4.1 The Analysis of Bank Debt
To test the first hypothesis, the natural logarithm of short term debt less trade payables
(BankDebt) and the natural logarithm of total debt (T otalDebt) are used to measure
the credit constraints of the firm. Unfortunately, the data does not provide bank debt
specifically which is why I focus on both the proxy for bank debt along with total
debt in the firm. However, since the sample consists of small Danish firms (see Panel
C Table 2.3 on page 57), it is reasonable to assume that short term debt less trade
payables primarily consists of bank loans.23 The main estimated model is as follows
with robust standard errors clustered at firm level.
BankDebtit =β0 + β1 T reatmentit + β2 P ostit + β3 T reatmentit × P ostit +
β4 Sizeit + β5 ROAit + β6 F ixedit + β7 Cashit + (2.1)
β8 Growthit + β9 N egEqit + β10 lnAgeit + it
Treatment is an indicator variable equal to 1 for all firms that eventually experience
a bank merger, 0 otherwise. Post is equal to 1 in the post-merger period, 0 otherwise.24
23
Besides trade payables, short term debt can also include tax, accruals and debt securities. The
data only provides the total short term debt and trade payables.
24
Recall that each treatment firm is matched with a comparable control firm based on the pre-
event period. Therefore the variable Post is equal to 1 in the post period for the specific treatment
and control firms, i.e. Post varies for each pair of treatment and control firm.
T reatment × P ost is an indicator variable of 1 in all years after the bank merger for
the treatment firms only. Thus, T reatment × P ost is the variable of interest and
shows the effect of bank merger activities on the credit availability for firms that are
customers in the target bank, i.e. the difference-in-difference estimator. The control
variables included in the model are firm specific variables (see Table 2.3 on page 57 for
descriptive statistics). Firm characteristics of SMEs are relevant for the bank when
deciding whether to grant a loan or not and based on prior literature (Cantillo and
Wright, 2000; Wagenvoort, 2003; Bonaccorsi di Patti and Gobbi, 2007; Degryse et al.,
2011), the following variables are therefore included as controls: size (log of total
assets), the profitability of the firm (ROA), the ratio of fixed assets over total assets
(Fixed), the ratio of cash to total assets (Cash), yearly growth in sales (Growth),25
the variable NegEq that is an indicator variable of 1 if the firm has negative equity, 0
otherwise and the natural logarithm of firm age in years.
The coefficients of β1 , β2 and β3 are specific for the difference-in-difference metho-
dology and specifically show the following:
β1 =(BankDebtTP reatment
re ) − (BankDebtControl
P re ),
β2 =(BankDebtControl
P ost ) − (BankDebtControl
P re ) and

β3 = (BankDebtTP reatment
ost ) − (BankDebtTP reatment
re ) −

(BankDebtControl
P ost ) − (BankDebtControl
P re )
In effect, T reatment controls for any permanent differences between the treatment
and the control group. The coefficient on β2 shows the difference from before to after
the bank merger for the control group only, but intuitively Post captures the common
trends for the treatment and control groups between the pre- and post-merger period,
25
According to Danish GAAP §32, small firms (class B) can choose to disclose an aggregate gross
profit(loss) instead of net sales. Information on net sales is missing in 78% of the observations whereas
gross profit is only missing in 15% (in the 5 year sample), hence I calculate the variable Growth using
net sales, if available, and otherwise I use gross profit (excluding those with a gross loss).
2.4. Methodology 63
respectively. If the level of bank debt in general declines between the two periods,
then Post will capture this variation. Hence, β3 shows the effect on bank debt for the
treatment firms compared to the control firms in the period after the bank merger.
I apply three types of fixed effects as additional controls throughout the paper.
First, all analyses include year fixed effects to control for business cycles and changes
in unobservable factors over time which are common across the sample. Second, I
use bank fixed effects to control for the unobservable bank characteristics that might
be correlated with the dependent variable in the model, but also correlated with the
decision to merge. There may be several different reasons as to why banks decide to
merge. If bank mergers are caused by bad customers and therefore poor performance of
the bank, then one might argue that bank mergers are endogenous events for customers
of that particular bank. This concern is addressed with the use of bank fixed effects
which will control for any permanent differences between banks, for example if one
bank is generally more risky than another bank.26 Third, all analyses include industry
fixed effects and thereby firms are compared within industries, removing any time-
invariant differences.27
To isolate the effect of the bank merger, two samples are constructed including
either one or five years before and after the bank merger, respectively. Hence, analyses
on short term effects of bank mergers include only one year before the merger, the
year of the merger and one year after the bank merger, whereas long-term analyses
include five years before/after the event.
26
Because of the long period of analysis I also allow for the bank fixed effect to vary over two
periods, i.e. 2000-2005 and 2006-2011. This does not change results substantially.
27
Following Statistics Denmark, firms are categorized into ten groups of industries (similar
to NACE): Agriculture, manufacturing, construction, transportation, information, financial ser-
vices/insurance, real estate, other business (knowledge-based), public administration and arts. See
Appendix A on page 109 for further details.
2.4.2 The Analysis of Firm Performance
Next, to test Hypothesis 2, I replace the dependent variable with Return on Assets
(and naturally exclude ROA as explanatory variable) to analyse if bank mergers have
implications for firms’ operating performance. The model of analysis is stated as
follows with robust standard errors clustered at firm level.
ROAit =β0 + β1 T reatmentit + β2 P ostit + β3 T reatmentit × P ostit +
β4 Sizeit + β5 F ixedit + β6 Cashit + (2.2)
β7 Growthit + β8 N egEqit + β9 lnAgeit + it
T reatment × P ost is the variable of interest, i.e. the difference-in-difference estimator

of firms exposed to bank mergers relative to the control firms and the model controls
for firm characteristics as already defined in Equation 2.1. Additionally, the model
includes year, industry and bank fixed effects.
2.5 Results
Do bank mergers affect small business lending? This question has been addressed in
several studies but with inconclusive results. In the following sections, I test if firms
are affected in their bank debt (Hypothesis 1) and operating performance (Hypothesis
2) when they are exposed to a bank merger.
2.5.1 The Effect of Bank Mergers on Bank Debt
Table 2.5 on the next page tabulates the results of Equation 2.1 analysing the effect
of mergers on the credit availability of firms, where T reatment × P ost indicates the
difference-in-difference estimates for firms exposed to a bank merger relative to the
control firms. Recall, that I expect to find a negative coefficient on the T reatment ×
P ost variable if firms are experiencing credit rationing following a bank merger.
2.5. Results 65
Table 2.5: The effect of bank mergers on bank debt and total debt
1 Year 5 Years
Bank debt Total debt Bank debt Total debt
Treatment 0.023 0.046** 0.048** 0.041**
(0.025) (0.019) (0.022) (0.018)
Post -0.015 -0.024** -0.026* -0.027**
(0.015) (0.011) (0.013) (0.011)
Treatment×Post 0.004 0.017 -0.005 0.015
(0.019) (0.013) (0.018) (0.014)
Size 1.001*** 1.091*** 1.014*** 1.116***
(0.009) (0.009) (0.008) (0.008)
ROA -0.477*** -0.515*** -0.385*** -0.474***
(0.061) (0.05) (0.039) (0.034)
Fixed -0.744*** 0.089** -0.684*** 0.047
(0.039) (0.039) (0.032) (0.029)
Cash -0.589*** -0.469*** -0.574*** -0.448***
(0.056) (0.05) (0.041) (0.035)
Growth 0.023*** 0.026*** 0.026*** 0.03***
(0.006) (0.004) (0.004) (0.003)
NegEq 0.481*** 0.41*** 0.474*** 0.419***
(0.029) (0.02) (0.021) (0.015)
lnAge -0.098*** -0.096*** -0.071*** -0.053***
(0.011) (0.01) (0.009) (0.008)
R2 29.51% 83.60% 34.27% 56.13%
No obs. 18,323 18,313 43,821 43,821
The table shows the results of Hypothesis 1, i.e. the effect on log of short term debt less
trade creditors and log of total debt based on samples with one and five years before and
after the merger, respectively. All models include firm controls (see Table 2.3) as well as
year, bank, and industry fixed effects. Robust standard errors are given in parentheses;
standard errors are clustered at firm level. The symbols *, ** and *** denote significance
at 10%, 5%, and 1%, respectively.
The results show that the levels of bank debt and total debt for the corporate
customers of banks that merge are not significantly different from comparable firms
that are not exposed to bank mergers. T reatment shows the difference between the
treatment and the control group in the pre-period, i.e. that treatment firms on ave-
rage had significantly higher bank debt and total debt than the control group. The
coefficient on P ost shows a statistically significant decline from the pre to the post
period for the control group, specifically. This shows that firms without bank changes
are more capital constrained than those firms being exposed to a bank merger when
comparing the change for controls firms (-0.024) with the change for treatment firms
(-0.024 + 0.017), i.e. the total debt of the treatment firms is 1.7% higher than the
total debt of the control firms in the 1 year sample.
The control variables generally have high explanatory power in the model, showing
that larger and high growth firms have more bank debt. Firms with more collateral
(Fixed) have lower bank debt but higher total debt which may be because total debt
includes mortgage loans. Finding a negative relation between cash and bank debt
is not surprising because small firms are found to have a negative relation between
cash and credit (Bonaccorsi di Patti and Gobbi, 2007; Wagenvoort, 2003). Firms with
negative equity have higher bank debt and total debt. Finally, the results show that
old and more profitable firms have less debt, which is in line with the findings of Hall
et al. (2004), as these firms are better able to accumulate generated earnings and use
these funds for future growth, which makes them less dependent on external funding.
Overall, the results provides no indication that firms are financially affected by
bank mergers, neither as an immediate effect nor in the long run analysis, hence there
is no empirical support for Hypothesis 1. Therefore, I am not able to confirm prior
literature that find that bank mergers have a temporary effect on credit availability
(Bonaccorsi di Patti and Gobbi, 2007; Berger et al., 1998) or are especially harmful
for small corporate customers (Degryse et al., 2011).
Next, the dependent variable is replaced with return on assets (Equation 2.2) to test
2.5. Results 67
if firms that are exposed to a bank merger are affected in their operating performance
relative to comparable firms.
2.5.2 The Effect of Bank Mergers on Firm Performance
The analyses so far suggest that firms that are exposed to a bank merger are in general
no more restricted in their access to bank financing than comparable firms without
any bank changes. Next, I test how bank mergers affects the operating performance
of corporate customers.
Table 2.6: Firm performance after bank mergers
1 year 5 years
Coef. Std.Err. Coef. Std.Err.
Treatment -0.009 (0.006) -0.008* (0.005)
Post -0.009** (0.004) -0.011*** (0.003)
Treatment×Post 0.011** (0.005) 0.011*** (0.004)
Size 0.013*** (0.001) 0.020*** (0.001)
Fixed -0.039*** (0.005) -0.050*** (0.005)
Cash 0.147*** (0.010) 0.147*** (0.008)
Growth 0.016*** (0.002) 0.018*** (0.001)
NegEq -0.206*** (0.009) -0.204*** (0.007)
lnAge -0.008*** (0.002) -0.008*** (0.001)
R2 14.58% 15.26%
No Obs. 18,313 43,821
The table shows the results of Hypothesis 2, i.e. the effect on firm
performance measured as return on assets. Firm controls are as pre-
viously defined. All models include a constant as well as year, bank,
and industry fixed effects (not reported). The analysis is based on the 5
year sample. Robust standard errors are given in parentheses; standard
errors are clustered at firm level. The symbols *, **, and *** denote
significance at 10%, 5%, and 1%, respectively.
The results are presented in Table 2.6 and show a positive and significant effect
on return on assets for firms exposed to bank mergers relative to the control sample
in both the short- and long term analyses. Contrary to Degryse et al. (2011), these
findings points at a mechanism where bank mergers per se may in fact be beneficial for
small corporate customers. This could be a result of increased monitoring (Petersen

and Rajan, 1995) and higher efficiency of the acquiring bank (Berger et al., 1999)
contrary to the target bank. This is in line with Panetta et al. (2009) who find that
bank mergers improve banks’ abilities to screen their borrowers and adjust interest
rates according to the default risk of the specific firms. They attribute their findings to
improvements in information processing within consolidated banks and the increased
use of hard information.28 Hence, the analysis of the operating performance shows
that treatment firms have significantly higher return on assets after the bank merger
when compared to similar firms.
This finding may, however, merely be a result of survivorship bias, i.e. that the
new consolidated bank terminates the relation with the least profitable firms.29 To
address this argument, I test how firm characteristics affect the probability of leav-
ing/dropping the bank-firm relation (the causality is unknown, i.e. if the firm chooses
to leave or is dropped by the bank). For the year of the merger and for treatment
firms only, I specifically test the probability of leaving the bank as a function of the
firm controls used throughout the paper as well as year, industry and bank fixed ef-
fects. The results show that the probability of leaving the bank is not significantly
related to firm performance. However, the large firms are more likely to experience a
relation termination following bank mergers which contrasts Sapienza (2002), whereas
Degryse et al. (2011) argue that the probability of switching banks (as opposed to be-
ing dropped by the bank) is positively related with firm size (however only significant
for firms with multiple bank relations).
28
Hard information is quantitative such as for example financial statements.
29
Only around 9% of the firms leave in the year of the merger and around 7% leave in the following
year.
2.5. Results 69
2.5.3 The Effect on Subsamples
In the full sample there is no indication that bank mergers as such are harmful for
small corporate customers, in fact there is evidence to suggest the opposite. Recall that
the three possible explanations for finding a negative effect are: first, the size effect
that large banks lend more to larger firms. Second, the increase in market power
results in higher interest rates for corporate borrowers. Third, the disruption of the
bank-firm relation results in loss of soft information. Hence, none of the three mecha-
nisms mentioned above result in significant negative findings for the full sample of
bank mergers and small corporate borrowers. Next, the empirical analysis is repeated
employing subsamples and test the first two effects specifically, i.e. the size effect of
bank mergers and second, that local mergers result in increased market power of the
bank which has a negative effect on corporate borrowers.
Prior studies have paid much attention to the size effect of bank mergers and
whether a merger between a large and a small bank may reduce lending to small
business borrowers (Peek and Rosengren, 1995; Berger and Udell, 1995b; Berger et al.,
1998), although Strahan and Weston (1998) and Peek and Rosengren (1998) find little
reason for concern. The latter papers argue that most mergers take place between
small banks, that mergers of two small banks actually tend to increase small business
lending and the level of small business lending in the acquiring bank in the pre-merger
period tends to reflect the level of small business lending after the merger. This
suggests that the size effect of bank mergers is less of a problem. Motivated by this
literature, I perform the analysis on firms that are exposed to a bank merger where
one of the five largest banks in Denmark is the acquirer.30 I expect that small business
lending is harmed as a result of the increase in bank size supporting prior literature
that large banks devote less resources to small business lending.
Since prior literature finds that small firms tend to use local banks (Kwast, 1999;
Cyrnak and Hannan, 1999) but that concentration in the local market increases loan
30
The large banks are Danske Bank, Nordea, Jyske Bank, Sydbank and Nykredit Bank.
prices (Hannan, 1991) and decreases interest rates on deposits (Prager and Hannan,
1998), I test if firms that are customers in local targets or local acquiring banks are
affected by the merger. I expect that firms are harmed by local bank mergers because
of an increase in the bank’s market power and reduced competition between banks in
the local market.
To isolate the size effect of bank mergers and the potential increase in market
power, I test if bank mergers are harmful for small corporate customers when it is
a large merger (a large bank takes over a smaller bank) or when the bank merger
includes either a local target or a local acquiring bank.31 Three subsamples are created
with specific treatment firms and their unique control firms: the first sample contains
treatment firms that have had their bank acquired by one of the largest five Danish
banks as well as their specific control firms. The second sample includes corporate
customers in a target bank where the acquiring bank is located in the same area as the
firm along with the specific control firms, and the third sample includes firms where
the target bank is local to the firm along with the control firms for these specific
corporate customers.
The analysis of corporate customers exposed to a large acquirer shows a negative

but insignificant effect on the level of bank debt whereas total debt is significantly
higher in the post period for treatment firms compared to the control firms. The
coefficient of P ost is significantly negative, showing that total debt is significantly
reduced from the pre to the post period for the control firms specifically. The difference
between the pre and post period for treatment firms only can be shown by β2 +
β3 , i.e. an increase of 0.2% (-0.057+0.059). Such finding could suggest that small
business lending may not be harmed as such when the acquirer is one of the five
largest Danish banks and since total debt indeed is significantly higher for these firms
31
Local is an indicator variable of 1 if the firm and bank head quarters are located in the same
or an adjacent zip code, 0 otherwise. Unfortunately, the data does not allow me to determine if the
collaboration between a firm and its bank takes place at head quarters or local branch level. However,
Panetta et al. (2009) use a similar proxy.
2.5. Results 71
Table 2.7: The effect on bank debt and total debt, subsamples
Large acquirer Local acquirer Local target

Bank Total Bank Total Bank Total
Treatment 0.051 0.011 0.118*** 0.07* 0.122*** 0.078**
(0.038) (0.027) (0.044) (0.036) (0.045) (0.039)
Post -0.005 -0.057** -0.008 -0.03* 0.002 -0.006
(0.033) (0.024) (0.022) (0.017) (0.023) (0.018)
Treatment×Post -0.009 0.059** -0.055** -0.006 -0.051* -0.015
(0.034) (0.023) (0.028) (0.021) (0.028) (0.021)
Size 1.017*** 1.123*** 0.981*** 1.097*** 0.98*** 1.102***
(0.01) (0.01) (0.018) (0.017) (0.018) (0.017)
ROA -0.39*** -0.471*** -0.381*** -0.467*** -0.435*** -0.457***
(0.05) (0.044) (0.08) (0.066) (0.088) (0.074)
Fixed -0.712*** -0.005 -0.602*** 0.228*** -0.609*** 0.221***
(0.04) (0.037) (0.064) (0.057) (0.067) (0.058)
Cash -0.6*** -0.461*** -0.525*** -0.422*** -0.493*** -0.413***
(0.052) (0.044) (0.074) (0.062) (0.075) (0.063)
Growth 0.028*** 0.027*** 0.031*** 0.035*** 0.031*** 0.037***
(0.005) (0.003) (0.007) (0.005) (0.007) (0.006)
NegEq 0.469*** 0.425*** 0.459*** 0.381*** 0.475*** 0.374***
(0.027) (0.019) (0.038) (0.028) (0.042) (0.031)
lnAge -0.073*** -0.066*** -0.068*** -0.034** -0.076*** -0.024
(0.011) (0.01) (0.018) (0.015) (0.019) (0.016)
R2 33.48% 55.90% 33.26% 56.34% 32.68% 56.29%
No obs. 27,479 27,479 11,026 11,026 10,529 10,529
The table shows the results of the estimation of Equation 2.1 on subsamples and tabulates
the effects on bank debt and total debt. Control variables are as previously defined. All
models include a constant as well as year, bank, and industry fixed effects (not reported).
The analysis is based on the 5 year sample. Robust standard errors are given in parentheses;
standard errors are clustered at firm level. The symbols *, **, and *** denote significance
at 10%, 5%, and 1%, respectively.
than for the control firms, corporate borrowers may gain easier access to other types
of external financing, for example mortgage loans.32 For this subsample of the five
largest acquiring banks, unreported results also find trade credit to be significantly
higher (5.3% significance) in the 5 year sample, which supports the theory that the
implicated firms turn to alternatives to bank loans.
The analyses of local mergers suggest that firms with either a local acquiring bank
or a local target bank have significantly lower bank debt in the post merger period
compared to the control firms (i.e. a negative coefficient on T reatment × P ost),
suggesting that these firms are credit constrained. This negative effect is in line with
32
Since several of the largest banks own a mortgage institution, this argues in favour of easier
access to mortgage loans for these firms.
prior literature that shows how concentrated and uncompetitive markets suffer from
higher interest rates on corporate loans (Hannan, 1991) and as the distance to the
nearest competing bank increases, so do prices on small business loans (DeGryse and
Ongena, 2005). Hence, local bank mergers do not seem to be beneficial for small
corporate borrowers as they experience lower levels of bank debt than comparable
firms.33 The results should be interpreted with care because there is no information
on whether the relation with the bank is at branch level or at head quarter level
(the proxy Local is based on the head quarter). However, this is most likely to be
a problem for customers in one of the five largest banks that have many branches,
because small Danish banks are generally locally oriented. Therefore, the analyses are
also performed on a subsample containing only the firms where the local acquirer is
not one of the five largest banks. The statistical significance in the samples with a
local acquirer or a local target is driven by mergers with smaller acquirers, which is
reassuring for the ability of Local to capture how bank mergers in the firm’s local area
affect the firm’s access to bank debt.
The three subsamples show no significant effect on firms’ return on assets, hence
the strong significant effect shown in Table 2.6 is driven by non-local and small mergers
which supports that local bank mergers and mergers with large banks are not beneficial
for implicated corporate customers.
The results show that bank mergers with one of the five largest banks result in
higher total debt of the affected firms (and also higher trade credit) and if the merger
involves local banks (either a local target or acquirer), then the corporate customers
seem to experience lower bank debt than comparable firms. These significant findings
suggest that there is a size effect of bank mergers such that larger banks reduce lending
(or at least force the corporate customers towards other types of financing) and local
bank mergers result in less bank debt for the implicated firms.
33
However, unreported results show no significantly higher levels of trade credit.
2.6. Conclusion 73
2.6 Conclusion
As small businesses are the main component of the economy measured as the fraction
of the total number of corporations and the number of employees, provision of finance
for the small businesses is of the utmost importance. This sole fact makes analyses of
SMEs highly relevant. Also, the bank merger literature only provides little empirical
evidence on the direct effect on corporate customers in banks that are taken over by
or merging with another bank. One important caveat of prior studies is the lack of
small, single-relationship firms in the sample, which is crucial because these firms are
also the most bank-dependent and hence more likely to be influenced by exogenous
shocks in the bank-firm relation.
I perform two analyses in this study. First, I analyse the effect of bank mergers on
firms’ level of bank debt. Second, I show the effect on firms’ operating performance.
Based on the analyses, I conclude that small firms, that are customers in target
banks are not harmed by bank mergers per se since there are no significant effects
on bank debt and total debt. In contrast, the results on firm performance show that
treatment firms in fact have higher performance than comparable firms after the bank
merger and this effect is present both as an immediate effect and in the long term
sample. This could be a consequence of the evaluation and increased bank monitoring
of these firms after the merger possibly combined with a higher efficiency of the new
consolidated bank.
A subsample of firms exposed to a merger with one of the five largest Danish banks
as the acquirer shows a higher level of total debt for treatment firms relative to the
control group which may be a substitution effect as these customers may gain better
access to other types of lending, for example mortgage loans. When focusing on local
mergers, i.e. either a local target or a local acquirer, empirical evidence suggests that
these mergers may be harmful for small businesses as bank debt is lower than for
comparable firms in the post merger period.
Overall, bank mergers do not seem to harm small corporate borrowers as there
actually seems to be efficiency gains that have a positive effect on firms. However,
there is evidence to suggest that large bank mergers or local bank mergers may have
negative consequences for implicated firms when compared to similar firms that are
not exposed to any bank changes.
Given that most countries have a significant proportion of small, bank dependent
companies, the findings of this paper should be of particular interest for policy makers
because of the increasing number of bank mergers.
Chapter 3
The Effect of Bank Quality

on Corporate Customers
The Effect of Bank Quality on Corporate Customers
Marie Herly and Lene Gilje Justesen

Aarhus University
Denmark
Abstract
This paper examines how banks’ quality affects their ability to screen and moni-
tor customers. We particularly study the way a bank’s quality impacts the
performance of its corporate customers.
Bank quality is measured by financial stability, CAMELS ratio and financial
reporting quality. Controlling for the endogenous bank-firm match we do not
find a statistical significant association between bank quality and firm perfor-
mance. However, we find that bank monitoring is more important when alter-
native firm monitoring is weak, indicating that high quality bank monitoring
may function as a substitute for firms’ alternative monitoring devices.
Keywords: Bank quality, asymmetric information, firm performance, accoun-

ting quality.
JEL Classification: G21, M41, L14, L25.
We thank Florian Eugster, Vasso Ioannidou, Özlem Dursun-de Neef, Steven Ongena,
Charlotte Østergaard and workshop participants at the 2014 Nordic Accounting Conference
for helpful comments.
77
78 Chapter 3. The Effect of Bank Quality on Corporate Customers
3.1 Introduction
There is a general consensus that bank relationships are very important for firms
and that banks as intermediaries act as delegated monitors (Diamond, 1984; Fama,
1985; Boot, 2000). However, little empirical evidence exists on the effect of such
bank monitoring on small, informationally opaque firms and the way in which this
substitutes firms’ alternative monitoring devices. This paper empirically examines
bank-firm relations along two dimensions. First, the effect of bank quality on firm
performance under the assumption that banks of high quality have superior abilities
in screening and monitoring their customers.1 Second, whether bank monitoring can
substitute firms’ alternative monitoring.2
One important role for banks is to monitor borrowers, but the ability to monitor
is likely to differ across banks (Diamond, 1984; Fama, 1985). The true characteristics
and abilities of borrowers are unobservable because of information asymmetries, but
through pre-loan screening and post-loan monitoring banks can assess the quality of
each firm. However, monitoring is costly and only high quality banks are assumed to
possess the ability and resources to carry out the necessary screening (Chemmanur
and Fulghieri, 1994). Compared to public debt, banks have the advantage that they
can adjust contract terms or interest rates through monitoring over time (Berger and
Udell, 1995a) and thereby prevent opportunistic behaviour (Mayer, 1988; Holmstrom
and Tirole, 1997). There are two possible outcomes of bank monitoring on firm per-
formance. On the one hand, continuous monitoring of the firm decreases asymmetric
information and may reinforce higher sales profitability through an easier access to
credit (Degryse and Ongena, 2001) and bank confidentiality.3 Hence, easier access
to credit allows firms to pursue their investment opportunities and thereby enhances
1
Our main variable of interest, bank quality, is defined broadly as bank stability, performance
and financial reporting quality. See Section 3.3.2 on page 91.
2
These alternative monitoring devices are CEO/chair duality, ownership structure, number of
bank relations and changes in auditor.
3
Especially for firms in certain industries or competitive environments it may be fatal if proprie-
tary information is leaked to competitors, hence the confidentiality of banks is important.
3.1. Introduction 79
firm growth and profitability. On the other hand, banks may exploit their information
monopoly which may result in a hold up problem (Boot, 2000). For example, Wein-
stein and Yafeh (1998) find Japanese firms in close bank relations to experience slower
growth rates and lower performance which they attribute to a hold up problem. Simi-
lar results are found by Weinstein and Yafeh (1995) and Houston and James (1996),
but these studies are all based on listed firms, a significant difference compared to the
present paper.
Research on public firms suggests that high quality banks can certify the quality
of current and possible future borrowers, resulting in higher firm value (Ross, 2010;
Bushman and Wittenberg-Moerman, 2012). Banks with high monitoring abilities also
charge higher interest rates (Coleman et al., 2006) but despite these higher rates, bank
monitoring still adds value to the borrower (Billett et al., 1995; Lee and Sharpe, 2009).
We therefore analyse how bank quality and monitoring affect firm performance. We
also analyse how this monitoring differs with alternative monitoring mechanisms. We
build our prediction on the governance substitution theory proposed by Williamson
(1983), who suggests that demand for one governance mechanism increases when other
governance mechanisms are weak. Following this intuition, we predict that bank
monitoring is more important when alternative monitoring mechanisms are weak. To
our knowledge this is the first study to explicitly test the governance substitution
hypothesis between firms’ alternative monitoring and bank monitoring, even though
banks play an important role as monitors.
We exploit unique Danish data that link each bank to its portfolio of corporate
customers, with the purpose of examining the monitoring and certifying role of banks
in relation to their customers. When answering our research questions we use an
instrumental variable two-stage approach to alleviate the selection issues inherent
in the research design, thereby effectively controlling for the non-random bank-firm
match. We propose two instruments to control for the endogeneity problem, namely
the number of banks in the firm’s area and the distance between the firm and its bank.
Both instruments powerfully explain the bank-firm match.
The difficulty in measuring the ability of banks to screen and monitor their bor-
rowers is reflected in prior literature which has used banks’ credit rating (Billett et al.,
1995), loan loss reserves (Johnson, 1997), bank size or the quality and quantity of
bank employees (Coleman et al., 2006) as proxies. We develop a measure of bank
quality based on financial performance and attitude towards risk and expect that this
measure is positively associated with the ability to monitor although we recognise that
this is, of course, not a perfect proxy for the monitoring ability of banks. The measure
consists of three components: First, a risk measure developed by the Danish Financial
Supervisory Authority specifically for Danish banks, focusing on growth and diversi-
fication of lending, funding and liquidity coverage. Second, a proxy for the regulatory
CAMELS ratio, which captures bank capital, asset quality and performance. Third,
two measures of bank financial reporting quality, namely discretionary loan loss pro-
visions and security gains and losses, respectively. The three measures of bank quality
complement each other as they capture three distinct features of the overall quality
of Danish banks, and they rest on the assumption that high quality banks wish to
maintain a high asset quality (Chan et al., 1986).
Contrary to our expectations, we find no association between bank quality and

the performance of their corporate customers and hence cannot document that bank
monitoring differs with the bank’s own quality. We do, however, find that bank
monitoring substitutes poor alternative firm monitoring. In particular, we find that
firms with poor alternative monitoring measured by either CEO/chair duality or a high
ownership share have significantly greater benefit of bank quality on their performance.
In other words, a firm with weak alternative monitoring benefits from having a high
quality bank whose monitoring in turn lowers asymmetric information and increases
firm performance.
We contribute to the literature by linking two strands of literature, namely the

monitoring role of banks on the one hand and the effect of bank monitoring on firm
3.2. Previous Literature and Hypotheses Development 81
performance on the other hand. This latter mechanism is often hard to observe empiri-
cally because of data restrictions. We also shed new light on how a banking relation-
ship serves as a monitoring tool when alternative monitoring mechanisms fail. Our
results are particularly interesting for stakeholders who are worried about asymme-
tric information between banks and their corporate customers, because we show that
high quality banks serve as a powerful monitoring tool when alternative monitoring
is weak. This study is also of interest to bank regulators, because it shows that the
capital and liquidity ratios on which banks are regulated can have real effects on the
bank’s customers.
The remainder of this paper is structured as follows: Section 3.2 outlines related
literature and develops our hypotheses, while Section 3.3 presents the sample, the
calculation of key variables and the descriptive statistics. Our research questions
concerning the association between bank quality and firm performance, and the sub-
stitution effect of bank monitoring when alternative monitoring is weak are tested in
Section 3.4. The final section concludes.
3.2 Previous Literature and Hypotheses

Development
Especially in relation to small business financing, banks gather valuable information

in the course of a firm relationship, resulting in an informational monopoly (Boot and
Thakor, 2000). Through their monitoring over time, banks can prevent opportunistic
behaviour by the firm by setting loan terms to improve customers’ incentives and
by renegotiating these terms when necessary. In other words, banks discipline their
borrowers. Since banks have a comparative advantage in monitoring because they
possess proprietary information, they act as a delegated monitor on behalf of the
lenders (Diamond, 1984).4 Akhigbe and McNulty (2011) show empirically that bank’s
monitoring efforts are value enhancing such that banks that allocate large resources to
customer monitoring are more profit efficient. Hence, it is worth the while for banks
to monitor customers.
A related stream of literature documents that the monitoring effects differ across
banks. Empirical work has found that the market reaction to bank loan agreements
is generally positive and Billett et al. (1995) show that the borrower’s abnormal stock
return is in fact higher if the lender has higher credit ratings, suggesting that a high
quality bank relation is even more positively valued by investors. Lee and Sharpe
(2009) find similar results in a later study.
There are at least three reasons why the monitoring of a high quality bank would
lead to higher performance for its customers. First, previous research suggests that
firms with a close bank connection have easier access to capital (Degryse and Ongena,
2001; Fama, 1985) making it possible for firms to fund new profitable projects and
pursuing their growth potential, which increases firm value. Similarly, Agarwal and
Elston (2001) and Kang and Stulz (2000), among others, find that firms with close ties
to a bank perform better than independent firms. Second, previous research also shows
that the quality of the lender can have a direct effect on the borrower (Chemmanur and
Fulghieri, 1994), implying that high quality bank loans have a certification effect that
makes it easier for firms to attract additional finance, which in turn should improve
firm performance. For instance, Fok et al. (2004) argue that high quality banks should
be able to monitor borrowing firms more effectively, and show that reputation and loan
ratios of the lending bank are important factors for explaining firm performance. The
implications of these studies are that high quality lenders act as a quality stamp and
enhance the firm value of their borrowers. Third, Yosha (1995) argues that bank debt
4
Freixas and Rochet (2008) define monitoring broadly as the screening of projects before loan
giving (adverse selection), preventing opportunistic behaviour during the realisation of the project
(moral hazard) and punishing or auditing a borrower who fails to meet contractual obligations (costly
state verification). Although monitoring is costly, the benefits in terms of making good loans and
preventing loan losses will outweigh these costs (Diamond, 1984).
reduces the possibility of proprietary information being leaked to rival firms, which
reduces the cost of disclosure for the firm. Such a reduction in cost should lead to
higher firm value.
This leads us to believe that through its ability to monitor firms over time, a high
quality bank has a positive effect on the performance of its customers. However, some
research would argue that the opposite may also be true. For example, Rajan (1992)
shows that a close bank-firm relationship could result in the bank extracting rents, and
Weinstein and Yafeh (1998) support this argument in an empirical study of Japanese
bank-firm relationships.
We shape our first hypothesis based on the previous literature: first, that banks as
delegated monitors invest in producing proprietary information to evaluate the true
quality of customers and that the ability to screen and monitor customers differs with
the bank’s own quality and second, that high quality bank monitoring leads to higher
customer performance. We therefore predict that the ability of a bank to monitor
and discipline its borrowers is positively associated with its own quality. Specifically,
high quality banks are superior in the pre-loan screening and post-loan monitoring
and hence their corporate customers have higher performance. Stated formally:
Hypothesis 1: High quality banks have corporate customers with high performance
The relation between high quality banks and firm performance predicted in Hy-
pothesis 1 rests on the assumption that high quality banks have better screening
and monitoring skills than low quality banks. In the next hypothesis, we examine
whether the effect of monitoring on firm performance differs with the level of firms’
other monitoring sources. This prediction rests on the substitution theory proposed
by Williamson (1983), who argues that governance structures arise as a result of the
individual needs of each organisation. Specifically, if a certain governance mechanism
is limited, a demand for other governance mechanisms arises. Using this argument we
expect that the need for bank monitoring is higher when other monitoring or gover-
nance mechanisms are weak. In particular, when a firm’s other governance mechanisms
are weak, the effect of bank quality on firm performance is more pronounced. Gover-
nance substitution is especially likely in our sample that consists mainly of small and
informationally opaque firms that are mostly financed by bank debt, because banks
have increased incentives to monitor the management through their role as concen-
trated debt holders (Hillier et al., 2008). We therefore expect that firms with poor
alternative monitoring benefit more from having a high quality bank. This intuition
translates into our second hypothesis:
Hypothesis 2: The effect of high quality banks on firm performance is more

pronounced for firms with poor alternative monitoring
We consider four alternative monitoring mechanisms beyond bank lending, namely

CEO/chair duality, ownership structure, multiple banking relationships and change in
auditor. Below, we elaborate on why they are expected to influence the effect of bank
quality on firm performance.
CEO and Chairman of the Board Duality Prior research suggests that boards
should consist mainly of independent directors because otherwise the boards fail to
fulfil their monitoring role (Fama and Jensen, 1983; Johnson et al., 1996). The con-
centration of power resulting from CEO/chair duality hinders effective monitoring of
the CEO and may increase potential conflicts of interest (Booth et al., 2002). As
chair of the board, the CEO has more power over decisions and the practices of the
board and can even control the information available to other board members (Jensen,
1993). We therefore predict that firms with CEO/chair duality are less monitored and
therefore gain more from bank monitoring; as a consequence, the effect predicted in
Hypothesis 1 is more pronounced for these firms.5
5
Please note, that according to the Danish Companies Act (i.e. the law for joint-stock companies,
in Danish A/S), a member of the management board cannot be appointed chairman, hence CEO/chair
duality is only possible for the other types of limited liability companies which is also the reason for
the low number of observations with CEO/chair duality.
However, the opposite may also be possible. In particular, Brickley et al. (1997)
suggest that CEO/chair duality may also be beneficial, because there are several
costs associated with splitting the roles, among others agency costs of controlling the
behaviour of the chairman, information costs and costs of inconsistent decision making
with shared authority.
Ownership Structure As stated by Desender et al. (2013), the importance of mo-

nitoring depends on the ownership structure. Dispersed shareholders may not have
the incentives and skills to monitor and may also find it difficult to coordinate their
efforts (Aguilera, 2005; Desender et al., 2013). The convergence of interest hypothesis
proposed by Jensen and Meckling (1976) suggests that managers who own a large
portion of a firm will act more in the interest of the shareholders. In other words,
if the manager owns the entire firm, there are no agency costs. However, this also
means that if ownership is high (above 50%) and is an internal owner (i.e. the owner
is also the manager), then the monitoring is weak because there are no independent
shareholders. Additionally, as predicted by the entrenchment hypothesis (Morck et al.,
1988; Weisbach, 1988), managers gain so much power as majority owners that they
may use the firm to promote their own interests rather than the interest of other
shareholders.
Based on the sample of analysis, we expect that firms with single owners with
more than 50% shares are poorly monitored and will therefore benefit more from the
monitoring performed by the bank.
Multiple Banks The number of bank relationships is also likely to determine the
degree of additional monitoring and thus to impact the effect of bank quality on firm
performance. Castelli et al. (2012) show that having few bank relations reduces infor-
mation asymmetry and Carletti (2004) argues that the bank’s incentives to monitor
depends on whether it is the sole lender to a firm. If not, two-bank lending suffers
from duplication of efforts which may lead to free-riding such that multiple banking
relationships in fact result in less monitoring of the firm. They attribute this finding to
the fact that single-bank relationships have lower information asymmetries and hence
single banks can more easily withstand agency costs (Rajan, 1992). Similarly, Foglia
et al. (1998) and Carletti et al. (2007) describe how multiple banking relationships
weaken the discipline exercised by the banks because of free-riding problems. Finally,
considerable evidence shows that firm profitability decreases as the number of bank
relationships increases (Degryse and Ongena, 2001; Castelli et al., 2012) and that poor
performing firms that take on an additional bank continue to perform poorly after-
wards (Farinha and Santos, 2002). Taken together, the evidence outlined above leads
us to expect that the performance of firms with multiple banks is more affected by
bank quality.6
However, the opposite could also be true. In particular, firms with multiple banks
may have higher performance as documented by Weinstein and Yafeh (1998) or choose
a second bank to overcome problems of credit rationing (Farinha and Santos, 2002).
In addition, multiple bank relationships could also mitigate hold-up problems where
banks obtain information monopoly and consequently charge non-competitive loan
rates (Rajan, 1992).
Auditor change Our final measure of firm monitoring is a change in auditor which
results in loss of information but may also serve as a signalling device.7 An auditor
change can erode financial reporting because the firm managers may choose the au-
ditor opportunistically (opinion shopping), and the auditor change could be caused
by irregularities within the firm (Bockus and Gigler, 1998). In general, prior re-
search suggests that auditor changes are associated with increased auditor litigation
risk (Krishnan and Krishnan, 1997), higher firm risk (Johnstone, 2000) and income
increasing earnings management (DeFond and Subramanyam, 1998). This evidence
suggests that firms changing auditors are troubled and hence could benefit from the
6
Note that this hypothesis does not take into account the quality of the second bank.
7
Unfortunately, our data does not allow us to distinguish between auditor resignations and auditor
dismissals. Resignations are generally found to be more associated with risky and unprofitable firms
than dismissals (Catanach et al., 2011).
monitoring of a high quality bank. We therefore predict that the performance of firms
that change auditor is more affected by a high quality bank than firms that do not
change auditor.
3.3 Research Design

This section provides an overview of the sample selection followed by the development
of the composite measure of bank quality.
3.3.1 Sample Description
We use a unique Danish panel data set from Experian, which contains financial state-
ments, ownership data, industry classification, type and status of the firm, auditor(s)
and the name of each firm’s bank(s). The information about the bank connection
either stems from the financial statements or in the absence of such information, Ex-
perian has collected the information manually by contacting the firms directly. This
information is not available for all Danish firms, nor are the financial statements.
Therefore, we start by selecting firms with both the financial statements and the bank
information available. 8
The sample selection process is displayed in Table 3.1.
The data set of corporate customers is linked to accounting information from Dan-
ish banks. This information is from Bankscope which, however, does not cover all
Danish banks. Table 3.2 presents an overview of the total number of banks in Den-
mark between 2000 and 2011 as well as the number of banks in each year for which
we have the necessary information to calculate the BankQuality variable. The number
of banks in Denmark decreases significantly over the sample period due to numerous
bank consolidations (the banks available in BankScope do not seem to be particularly
affected by this, presumably because only the larger banks are included).
8
For a thorough description of the data, please see Appendix A on page 109. Note that we have
sorted the data on the financial statements slightly differently than for Bank Consolidations and
Small Business Lending: Empirical Evidence from Denmark.
Table 3.1: Sample selection process
Selection criteria Firm year obs.

Less 13,314 non private limited firmsa 745,377
Less 2,105 obs. with unequal assets and liabilitiesb 740,952
Less 1,768 obs. with suspected errorsc 739,184
Less 21,741 unconsolidated statements 708,046
Less 102,460 obs. of small firms (<EUR 100.000) 605,586
Less 18,735 obs. from before year 2000 586,851
Final sample containing financial statements (81,067 unique firms) 586,851
a) Only private limited firms that are required to report according to Danish GAAP
are included. b) The sum of assets and liabilities should correspond to the total
assets that are reported in the financial statement. c) Suspected errors are those
with negative values in net sales, fixed assets, intangible assets, PPE, financial assets,
current assets, inventories and trade debtors.
Table 3.2: Number of banks in Denmark and in the sample of analysis

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Banks in
208 211 202 198 196 187 181 175 154 148 142 133a
Denmark
Banks in
46 41 42 42 54 63 67 67 86 86 85 63
sample
The table shows the number of banks in Denmark during the period of analysis from 2000 to
2011. This includes commercial banks, savings banks and co-operative banks from Denmark,
Greenland, the Faroe Islands as well as branches of foreign banks. The table also shows the
number of banks in the sample, namely the number of banks for which we are able to calculate
the variable BankQuality. a) In 2011, we only have the number of Danish banks, i.e. excluding
those from Faroe Islands and branches of foreign banks.
Table 3.3 tabulates the descriptive statistics for the firms in our sample, divided in
the lower and higher median of BankQuality. Bank quality and bank size are positively
associated such that on average large banks are of higher quality. With this in mind,
we see that our sample confirms previous evidence that small banks mostly lend to
small firms and large banks lend to large firms (Berger et al., 2005; Carter et al.,
2004), since the corporate customers of high quality banks are larger than those of
low quality banks measured with total assets. Customers of high quality banks also
seem to perform better, but this is likely to be correlated with the size differences.
Table 3.3: Sample description
High Quality Bank Low Quality Bank

Mean Median Std.Dev. Mean Median Std.Dev.
Firm variables
Assets 4,999* 826* 14,511 4,028 777 12,471
FirmROA 0.034 0.041* 0.207 0.035 0.042 0.212
FirmROE 0.214* 0.146* 1.047 0.229 0.160 1.075
FirmLeverage 2.812* 1.420* 8.924 3.024 1.505 9.458
FirmGrowth 0.785 0.041* 64.592 0.764 0.021 78.292
Age 14.32* 12.00* 11.89 13.40 11.00 11.31
Bank variables
Assets 173,183* 119,955* 150,624 147,053 18,876 195,429
BankROA 0.004* 0.005* 0.006 0.007 0.006 0.007
BankROE 0.099* 0.139* 0.089 0.106 0.121 0.095
Statistics for all firms in the entire sample period. All variables have been winsorized at the
1st and 99th percentile, respectively. In thousands EUR.
Assets is total firm assets, ROA is net income scaled by total assets, ROE is net income
scaled by total equity, Growth is the annual change in firm net income, Age is the number
of years from the date of registration at the Danish Business Authority. The bank variables
include total assets, return on assets and return on equity. * denote significant differences
at 1% level between the high and low quality groups based on a simple t-test (means) and
wilcoxon test (medians).
We also see that high bank quality does not translate into high bank performance.
This could be caused by fluctuations over the years or the reason might be that our
measure of bank quality is not a measure of good banks in all dimensions. We actually
find it reassuring that our measure of bank quality is not merely a proxy for the large
and best performing banks.
Tabel 3.4 shows the descriptive statistics of the sample based on the four measures
Table 3.4: Mean values based on firms’ alternative monitoring

Total Dual BigOwn Multiple ∆Auditor
sample Var=1 Var=0 Var=1 Var=0 Var=1 Var=0 Var=1 Var=0
% of total obs. 1.65 98.35 66.47 24.25 4.44 67.74 8.63 90.27
Firm variables
Assets 3,834 6,901 3,802 4,028 3,668 12,361 3,437 3,933 3,832
ROA 0.029 0.008 0.029 0.032 0.025 0.033 0.029 0.012 0.031
ROE 0.205 0.224 0.205 0.223 0.162 0.183 0.206 0.193 0.207
Leverage 2.903 2.925 2.902 3.039 20422 3.123 2.893 2.764 2.920
Growth 1.261 5.376 1.217 1.349 1.197 1.449 1.252 0.207 1.392
Age 12.82 12.26 12.82 12.89 13.74 18.02 12.58 12.57 12.82
Bank variables
Assets 160,825 165,281 160,732 163,584 155,336 262,920 154,058 167,799 159,915
ROA 0.006 0.006 0.006 0.005 0.006 0.004 0.006 0.005 0.006
ROE 0.102 0.103 0.102 0.102 0.104 0.096 0.103 0.091 0.104
Quality 49.694 49.7051 49.694 49.767 49.409 49.246 49.724 49.549 49.714
The table provides descriptive statistics of the sample based on the four measures of firms’ alternative
monitoring: CEO/chair duality, BigOwn for firms with one owner with more than a 50% share, firms
with multiple banks and firms with a change in auditor. Total sample show the mean values based on the
full sample. For each measure of firms’ alternative monitoring, the percentage share of total observations
with the dummy variables equal to either 1 or 0 is presented. Mean values are presented for firm and
banks variables as already described in Table 3.3. BankQuality is the composite measure of bank quality
consistent of financial stability, CAMELS rating and accounting quality (see Section 3.3.2).
of firms’ alternative monitoring, namely CEO/chair duality, firms with one large owner
(share above 50%), firms with multiple bank relations and firms that change their
auditor. Mean values are shown based on each of these four measures when set equal
to 1 or 0.9 The first row shows the percentage share of total observations that falls
under each of the categories. This does not sum up to 100% for each individual measure
because of missing observations. We see that in only 1.648% of the observations, a
firm has the same person as the CEO and chairman of the board, and we see this
duality in larger firms with a higher growth rate in net income, but otherwise similar
to the sample of firms without CEO/chair duality. The majority of firms have a large
shareholder with a share of more than 50%. These firms are comparatively large, have
high performance, high growth rates, high leverage and they also seem to have larger
banks and banks of high quality. Less than 5% of the firms (firm-year observations)
have multiple bank relations and these firms are large measured in total assets and are
9
The mean value of total assets for the full sample is lower than the mean values shown in Table
3.3. This is caused by the unbalance of the dataset where it is evident that firms with years of missing
bank information (or that the bank is not represented in BankScope) are small firms.
significantly older than the average company, which supports prior literature. Finally,
there is a change in auditor in 8.6% of total observations and those companies seem
to have lower performance and lower growth rates.
3.3.2 Measuring Bank Quality
The main variable of interest is bank quality as a bank of high quality is expected
to be better capable of monitoring their borrowers.10 This is based on Chan et al.
(1986), who argue that a bank’s incentive to screen and monitor their borrowers is
related to a desire to maintain a high asset quality. Our analyses build on an ongoing
bank-firm relation rather than on specific loan contracts where the bank would only
screen the firm ex ante. The advantage of an ongoing relation is that it builds on an
interim monitoring of the firm where the bank can prevent opportunistic behaviour
and moral hazard through continuous monitoring because they can punish the firm
on a timely basis (e.g. by increasing interest rates or denying new loans). We wish
to measure bank quality broadly in order to capture both the financial stability, the
attitude towards risk and the accounting quality of the bank, and we therefore include
these three components of quality into a composite measure. All bank quality variables
are defined in Table 3.5 on page 95 and described in detail below.
Financial Stability The Danish Financial Supervisory Authority (Finanstilsynet,
the Danish FSA) has outlined thresholds within five risk areas that banks should not
exceed, the so-called Supervisory Diamond (Tilsynsdiamant). Since 2011 all Danish
banks have been required to issue statements on how they relate to these thresholds
and the Danish FSA then publishes them on their homepage (Finanstilsynet, 2014).
The five thresholds are: 1) Sum of large exposures cannot exceed 125% of eligible
capital.11 2) Annual lending growth cannot exceed 20%. 3) Ratio of real estate loans
10
Proxies used in prior literature for bank monitoring include bank size, reputation, credit ratings,
loan loss reserves and bank labour.
11
A large exposure is one of more than 10% of adjusted capital.
to total loans cannot exceed 25%. 4) Funding ratio cannot exceed 1.12 5) Liquidity
coverage cannot fall below 50%.13 If one of these five thresholds is violated, the Danish
FSA issues an enforcement action.14 Since our sample period ends in 2011, we cannot
use the actual numbers published by the banks but we estimate them based on the
guidelines of the Danish FSA. Because of data restrictions, we cannot estimate the first
component, i.e. the sum of large exposures. For the last four measures, we compare
our estimations from 2011 with those reported by the Danish FSA to see if they are
similar. Our estimations and the numbers reported by the Danish FSA resemble each
other and so we are confident that our proxy for the Supervisory Diamond largely
captures the same underlying bank quality. The Supervisory Diamond is a powerful
proxy for financial stability in our sample because it has been constructed by the
Danish FSA and hence customised to the Danish bank market.
The four variables inspired by the Supervisory Diamond are constructed as follows:
Loansit − Loansit−1
LoanGrowthit = (3.1a)
Loansit−1
M ortgageLoansit
RealEstateExposureit = (3.1b)
Loansit
Loansit
F undingRatioit = (3.1c)
Depositsit + Equityit
CashAndEquivalentsit
LiquidityCoverageit = (3.1d)
Depositsit + CurrentLiabilitiesit
Since the Danish FSA assesses these four variables independently, we choose to do
the same such that each of these four variables is included in the composite measure
of bank quality independently. Low (high) values of LoanGrowth, RealEstateExposure,
FundingRatio (LiquidityCoverage) indicate high quality.
12
This is defined as the relation between total lending and working capital less short term bonds,
i.e. the stable funding.
13
Defined as the excess liquidity to the legal requirement in percent of the minimum legal require-
ment.
14
An enforcement action (Tilsynsreaktion) could be an enforcement notice, information of risk, a
fine or a police report (https://www.finanstilsynet.dk/da/Tal-og-fakta/Statistik-noegletal-analyser/
Tilsynsdiamanten.aspx).
CAMELS Ratings Our second measure of quality is a proxy for the CAMELS
ratings, inspired by Duchin and Sosyura (2014). This regulatory rating system rates
banks on six dimensions: Capital adequacy, Asset quality, Management, Earnings,
Liquidity and Sensitivity to market risk.
CAM ELSit = Cit + (A ∗ −1)it + M Eit + Lit + Sit (3.2)
Where C is total capital ratio, A is non-performing loans scaled by net loans, ME is net
income scaled by total assets, L is cash scaled by total deposits and S is current assets
less current liabilities scaled by total assets. As opposed to the measure of financial
stability, the Supervisory Diamond, where each of the four variables is included in
the composite measure independently, we include CAMELS as one variable in the
composite measure of bank quality. High values of CAMELS indicate high bank
quality.
Accounting Quality Our final measures of bank quality are two accounting quali-
ty measures, namely discretionary loan loss provisions (LLP) and security gains and
losses (SGL), respectively. Loan loss provisions arise from bank managers’ estimation
of loan losses on the balance sheet date and are recognised as an expense account
(Gebhardt and Novotny-Farkas, 2011). Loan loss accounting is interesting in an ear-
nings management context since it has material effects on banks’ earnings and balance
sheet amounts and requires a substantial degree of estimation and judgement (Nichols
et al., 2009).15 . We follow Beatty et al. (2002) and Cornett et al. (2009) in separating
the discretionary and non-discretionary parts of LLP as follows, with standard errors
15
Previous research has found evidence of both capital management, i.e. increasing LLP to boost
regulatory capital (Moyer (1990), Scholes et al. (1990) and Ahmed et al. (1999)) and earnings man-
agement, i.e. increasing (decreasing) LLP to lower (boost) earnings (Collins et al. (1995) and Anan-
darajan et al. (2007)). As discussed by Wall and Koch (2000), exercising discretion beyond what
the standard prescribes is not necessarily manipulation. Building up loan loss allowance during
good times and using part of the increase to absorb losses in bad times is not necessarily income
manipulation from a regulatory perspective.
clustered by year:
LLPit =β0 + β1 SizeBankit + β2 N P Lit
(3.3)
+ β3 LLRit + β4 Loansit + µit
Where LLP is the loan loss provision scaled by gross loans, SizeBank is the natural
logarithm of bank assets, NPL is non-performing loans scaled by gross loans, LLR
is the loan loss reserve scaled by gross loans and Loans is the natural logarithm of
gross loans. The absolute value of the residual from Equation 3.3 is the measure of
discretionary LLP and thus captures the amount of loan loss provisions not explained
by bank size, non-performing loans, loan loss reserve and total loans. High values of
discretionary LLP indicate low bank quality.
Our second measure of quality is the discretionary realisation of security gains and
losses (SGL). SGLs reflect the accounting gain or loss that arises when a bank sells an
investment security at a price different from the book value (Warfield and Linsmeier,
1992). Realising security gains and/or postponing security losses increases net income
and bolsters regulatory capital. Since divesting of financial securities is discretionary to
a large extent, bank managers have the ability to influence reported accounting income
by timing the sales of securities (Barth et al., 1990). We again follow Beatty et al.
(2002) and Cornett et al. (2009) in separating SGLs in their discretionary and non-
discretionary part when estimating the following regression (standard errors clustered
by year):
RSGLit = β0 + β1 SizeBankit + β2 U SGLit + β3 Capitalit + µit (3.4)
Where RSGL is realised security gains and losses scaled by total assets, SizeBank is
the natural logarithm of total assets and USGL is unrealised security gains and losses
measured by total securities scaled by total assets and Capital is total capital scaled by
total assets. As was the case above, the absolute value of the residual from Equation
3.4 is the measure of discretionary SGL, i.e. the part of RSGL which is not explained
by the variables in the model. Higher residual values indicate lower bank quality.
Table 3.5: Estimation of bank quality measures
Bank Quality Variables Estimation

Loan Growth Annual
Real Estate Exposure Mortgage Loans/Loans
Supervisory Diamond
Funding Ratio Loans/(Deposits+Equity)
Liquidity coverage Cash/(Deposits+Curr. Liabilities)
Capital Adequacy Capital Ratio
Asset Quality Non-performing Loans/Loans
Management,
CAMELS Net Income/Assets
Earnings
Liquidity Cash/Deposits
Sensitivity to Risk (Curr. Assets-Curr. Liabilities)/Assets
Discretionary LLP Equation 3.3
Accounting Quality
Discretionary SGL Equation 3.4
The table shows how each of the three parts of the overall composite measure of bank
quality is estimated. The variables in bold are those included in the composite measure,
BankQuality.
Next, the seven measures (LoanGrowth, RealEstateExposure, FundingRatio, Liqui-

dityCoverageRatio, CAMELS, Discretionary LLP and Discretionary SGL) are trans-
formed into a composite measure based on ranking because the absolute values of the
individual variables are not comparable. The seven measures are estimated annually
such that each of the measures is ranked in 100 groups (percentiles) where low (high)
quality has the value of 1 (100), i.e. higher values indicate higher quality on all me-
trics.16 For each bank in each year, we then take an average of the seven measures
to obtain a composite measure of bank quality between 1 and 100, which is in line
with previous literature (e.g. Bushman et al. (2004)). In other words, BankQuality is
a composite measure of the annual estimates of the seven measures of bank quality:
LoanGrowth, RealEstataExposure, FindingRatio, LiquidityCoverageRatio, CAMELS,
Discretionary LLP and Discretionary SGL. Hence, these are the Supervisory Diamond,
CAMELS and accounting quality. These measures should not be considered substi-
tutes since they capture three separate features of bank quality. Therefore, we believe
16
That is, ranks are descending in absolute values of LoanGrowth, RealEstateExposure, Funding-
Ratio, DiscretionaryLLP and DiscretionarySGL because high absolute values indicate low quality
and we wish to have high quality for high values.
that this composite measure is a superior proxy for the monitoring ability of banks
compared to each individual measure. Due to the inherent problems of measuring
the screening and monitoring carried out by the banks we also acknowledge that the
three bank quality measures may not fully capture the overall quality of the bank with
respect to our hypothesis that high quality banks have high performance customers.
A possible caveat is that our measure of bank quality may fluctuate over time whereas
the ability to monitor is probably relatively constant. However, the measure is based
on yearly relations between banks hence fluctuations based on general conditions in
the economy have no effect since they affect all banks simultaneously.
Table 3.6: Correlations of bank quality measures
Loan- RealEstate- Funding- Liquidity- Accounting-

CAMELS
Growth Exposure Ratio Coverage Quality
LoanGrowth 1
RealEstateExposure -0.3006 1
FundingRatio -0.0527 0.9048 1
LiquidityCoverage 0.0072 0.637 -0.194 1
CAMELS 0.2917 -0.216 -0.4214 0.7003 1
AccountingQuality 0.0474 -0.2367 -0.6066 0.3837 0.3534 1
LoanGrowth is the annual percentage change in total loans, RealEstateExposure is mortgage backed up
loans scaled by total loans, FundingRatio is total loans scaled by total equity, LiquidityCoverage is cash
and equivalents, scaled by current liabilities, CAMELS is from Equation 3.2, AccountingQuality is the
average of Equations 3.3 and 3.4. All variables are ranked values and Pearson correlations are annual.
All values are winsorized at the 1st and 99th percentile, respectively.
Table 3.6 shows annual correlations between the ranked bank quality proxies. Re-
call that we do not expect those measures to be substitutes, instead they each capture
distinct components of the overall quality. Therefore, it is not surprising that some of
the metrics are negatively correlated. For instance, the negative correlation between
FundingRatio and LiquidityCoverage points at the well-known trade-off between cash
holding and loan output (see, e.g., Holmstrom and Tirole (1997)), while the nega-
tive correlation between RealEstateExposure and LoanGrowth implies that growth in
lending stems from sources other than mortgage. Note also that AccountingQuality is
negatively correlated with two other quality measures from the Supervisory Diamond
3.4. Relation Between Bank Quality and Firm Performance 97
measuring the lending level (RealEstateExposure and FundingRatio). This shows that
high levels of lending per se do not lead to low accounting quality measured with
discretionary loan loss provisions. The reason is that the level of loans is effectively
controlled for in the expectation model of loan loss provisions (Equation 3.3). So if
the level of lending is high (which is the case if RealEstateExposure and FundingRatio
are high) and loan loss provisions are not overstated, the residual from Equation 3.3
is small, indicating high accounting quality. Overall, the fact that the six different
quality measures are not perfectly aligned reassures us that we are right in including
several measures of the overall bank quality since they do indeed capture different
components of this broad concept.
3.4 Relation Between Bank Quality and Firm

Performance
One of the primary roles of banks is to provide funding for corporate customers and
to screen and monitor the behaviour of these borrowers. The bank is expected to
monitor the firm on a continuous basis as opposed to pre-loan screening because the
relation with the bank is not based on loan contracts but on regular interaction, for
example through lines of credit. We argue that the ability of banks to monitor their
borrowers is positively correlated with the quality of the specific bank, i.e. that high
quality banks have better monitoring skills and are therefore better at disciplining the
borrowers. The interim monitoring done by the bank is expected to translate into
higher performance of the customers of a high quality bank.
3.4.1 Methodology
Recall that Hypothesis 1 predicts that firms with a high quality bank have higher
performance, because high quality banks have better monitoring skills and can disci-
pline and certify the quality of the firm. To test the relation between bank quality
and firm performance, we estimate the following regression with firm fixed effects and
year controls:
ROAit =β0 + β1 BankQualityit + β2 Sizeit + β3 Leverageit +

(3.5)
β4 Growthit + β5 lnAgeit + β6 Crisisit + µit
Where ROA is net income scaled by total assets, BankQuality is the composite
measure of bank quality, consisting of the average ranked values of Supervisory Dia-
mond (Equations 3.1a to 3.1d), CAMELS rating (Equation 3.2) and accounting quality
(Equations 3.3 and 3.4),17 Size is the natural logarithm of assets, Leverage is the sum
of short- and long-term debt scaled by total equity, Growth is the annual percentage
change in net income, lnAge is the natural logarithm of the age of the firm in years
and Crisis is an indicator variable equal to 1 if the year is 2008 and after, 0 otherwise.
The coefficient on β1 is the variable of interest in Hypothesis 1. Following the
intuition outlined in Section 3.2, we expect a positive coefficient such that higher
bank quality is associated with higher firm performance. We follow Fok et al. (2004)
and use ROA to measure firm performance because it is independent of the firm’s
liability structure and is a better performance measure than ROE, which is more
suitable for all-equity firms.18 The remaining variables are included to control for
other factors that may influence firm performance.19 Beyond standard firm-specific
variables such as growth and leverage, we include the indicator variable Crisis as an
additional control for the financial crisis in addition to our year controls.
When isolating the effect of bank quality on their customers’ performance, our
main concern is that the match between a firm and a bank is non-random.20 In par-
17
If the firm has multiple banks then the first mentioned bank is included in the analyses.
18
We have also used an alternative performance measure, return on net assets (RONA) defined as
net income/(fixed assets + net working capital). This yields similar results.
19
The control variables are current year and not lagged values because we do not attempt to
predict ROA based on firms characteristics in year t-1, but rather to remove the effect on ROA of
these variables in the current year.
20
Reverse causality is not an issue because it is not important if the firm chooses the bank or vice
versa, but the specific match between a firm and a bank is probably not a random match.
ticular, the independent variables in Equation 3.5 may determine firm performance
and at the same time be associated with the bank-firm match, for instance if firms with
better prospects choose high quality banks or vice versa. If this is the case, the vari-
able BankQuality is endogenous which can lead to inconsistent estimates (Heij et al.,
2004).21 Our research design attempts to alleviate this endogeneity by applying an
instrumental variable (IV) approach.22 Therefore, we need instrumental variables that
determine the bank-firm match, but are independent of the firm’s performance, i.e.
are correlated with the endogenous variable (BankQuality), but uncorrelated with the
variable of interest (ROA) so that it can be rightfully excluded from the second stage
regression. We choose two instruments based on previous literature (e.g. Knyazeva and
Knyazeva (2012); Bushman and Wittenberg-Moerman (2012); Ross (2010)), namely
the concentration of banks in the firm’s local area (NBanks) and the proximity of the
firm to the bank head quarters (Local). The bank-firm match is likely to depend on
the supply of banks in the firm’s local area such that when there are many banks
to choose between in the local area, the competition between banks is high and the
bank-firm match may therefore be a result of the firm choosing the bank that provides
the best terms rather than the bank that has the highest quality. Similarly, the proxi-
mity between the firm and its bank is more likely to determine a bank-firm match
because a firm would rather choose a local bank than one of high quality. Also, it is
highly unlikely that a firm would change their location for the sole purpose of getting
a closer bank relation (in physical distance).23 Recall that the firms in the sample are
small24 and prior research shows that small and informationally opaque firms choose
21
A Hausman test shows that the variable BankQuality is indeed endogenous.
22
Specifically, we apply the approach developed for the econometrical package STATA by Schaffer
(2005) which allows for firm fixed effects.
23
Unfortunately, our data does not allow us to determine if the collaboration between a firm and
its bank occurs at head quarters or local branch level. However, we still believe that the proximity
instrument sufficiently explains part of the bank-firm match. Gambini and Zazzaro (2013) use an
identical instrumental variable.
24
The mean of total assets is less than EUR 5 millions (see Table 3.3 on page 89) and on average,
firms are therefore categorised as small in the SME definition of the European Commission.
local banks because the physical proximity makes it easier to create strong relations
with the bank based on soft information (Meyer, 1998; Kwast, 1999; Stein, 2002). In
addition, as the distance between the bank and the firm increases, the probability
of small business loan defaults is increasing (DeYoung et al., 2008). Hence, the two
variables are suitable instruments for two reasons: First, the bank-firm match is likely
to depend on the supply of banks in the firm’s local area as well as on the physical
distance between the firm and its bank. Second, it is highly unlikely that the con-
centration of banks in the firm’s area or each firm’s proximity to its bank determines
its future performance. The instrumental variables are constructed as follows: The
number of banks in the firm’s area, NBanks, is the number of banks within the same
one-digit zip code scaled by the total number of banks in that year, while a bank is
considered Local if it is located in the same or an adjacent four-digit zip code region.25
To model the bank-firm match, the following first stage regression is estimated
with the two instruments included as regressors to determine bank quality:
BankQualityit =β0 + β1 Sizeit + β2 Leverageit + β3 Growthit +

(3.6)
β4 lnAgeit + β5 Crisisit + β6 N Banksit + β7 Localit + µit
Where NBanks is the number of banks in the firm’s area scaled by the total number
of banks in year t, Local is an indicator variable equal to 1 if the firm and its banks
are located within the same region, 0 otherwise and other variables are as previously
defined.
The right-hand side of Equation 3.6 consists of two parts: First, the factors that
determine the bank-firm match and at the same time may be associated with the
firm’s future performance (β1 to β5 ). For instance, the growth of a firm determines
the performance of the firm and may also determine the firm’s choice of bank. Second,
the factors that determine the bank-firm match, but are independent of the firm’s
future performance (β6 and β7 ). The predicted values from the first stage regression
25
Specifically, a local bank is located either in the exact same four-digit zip code or within ± 5%
of that zip code.
(Equation 3.6) are then included in the second stage regression (Equation 3.5) which
excludes the two instruments, thus effectively controlling for the endogenous bank-firm
match.
To test Hypothesis 2, i.e. that the effect of bank quality on firm performance is
more pronounced for firms with poor alternative monitoring, we include each of the
four measures of monitoring (described in Section 3.2) in the regression separately,
along with the interaction with BankQuality.
ROAit =β0 + β1 BankQualityit + β2 M onitoringit +
β3 BankQualityit × M onitoringit + β4 Sizeit + β5 Leverageit + (3.7)
β6 Growthit + β7 lnAgeit + β8 Crisisit + µit
Where Monitoring is one of four measures of monitoring: Dual is an indicator

variable equal to 1 if the CEO of the firm is also chairman of the board, 0 otherwise,
BigOwn is an indicator variable equal to 1 if a shareholder owns more than 50% of
the firm, 0 otherwise, Multiple is an indicator variable equal to 1 if the firm has mul-
tiple banks, 0 otherwise, and ∆Auditor is an indicator variable equal to 1 if the firm
changes auditor, 0 otherwise. The control variables are as previously defined. Hypoth-
esis 2 predicts a positive coefficient on β3 , the interaction term between Monitoring
and BankQuality, indicating that the effect of bank quality on firm performance is
exacerbated if alternative monitoring of the firm is weak.
As was the case in Equation 3.5, the second stage regressions are based on the
predicted values from the first stage to effectively control for the endogenous bank-
firm match.26 However, since we interact the endogenous variable BankQuality with
each of the four monitoring variables, this will result in two first stage results for each
regression which can be formulated as follows:
26
Results of the first stage regressions are not tabulated for H2 but are available upon request.
However, the table presenting the results (Table 3.8), tabulates the F-values for the joint test of the
instruments.
BankQualityit =β0 + β1 M onitoringit + β2 Sizeit + β3 Leverageit +
β4 Growthit + β5 lnAgeit + β6 Crisisit + β7 N Banksit +

(3.8)
β8 Localit + β9 N Banksit × M onitoringit +
β10 Localit × M onitoringit + µit
BankQualityit × M onitoringit =β0 + β1 M onitoringit + β2 Sizeit +
β3 Leverageit + β4 Growthit + β5 lnAgeit +
β6 Crisisit + β7 N Banksit + β8 Localit + (3.9)
β9 N Banksit × M onitoringit +
β10 Localit × M onitoringit + µit
Since our panel data set is unbalanced, a risk of sample selection bias does exist.
Sample selection bias arises if the observations in the dataset are not random, for
example if the firms that exit the sample are only poor performing firms. We test for
this as suggested by Verbeek and Nijman (1992) and find that there is no problem of
sample selection in the sample of analysis.27
3.4.2 Results
The result of the first stage regression, Equation 3.6, is tabulated in Panel A of Ta-
ble 3.7 on the facing page and explains the bank-firm match with the two instruments,
NBanks and Local.
We note that both instruments are significantly related to bank quality, indicating
27
Specifically, all regressions are estimated with three different additional regressors: A variable
counting the time-series of each firm, as well as two indicator variables showing whether the time-
series of each firm starts (stops) later (earlier) than the entire sample period.
Table 3.7: Relation between bank quality and firm

performance (H1)
Panel A: First stage regression

Coef. Robust Std.Err. T-stat.
Size 0.315*** 0.095 3.34
Leverage -0.006 0.004 -1.34
Growth 0.001 0.001 0.66
lnAge 0.892*** 0.159 5.63
Crisis -1.058*** 0.258 -4.11
NBanks -0.200*** 0.015 -14.09
Local -3.644*** 0.360 -10.14
Joint F-test 154.21
Sargan-Hansen p-value 30.61%
R2 2.23%
Panel B: Second stage regression
Coef. Robust Std.Err. Z-stat.
BankQuality -0.001 0.001 -0.93
Size 0.100*** 0.003 41.57
Leverage 0.001 0.001 1.63
Growth 0.001*** 0.001 5.93
lnAge 0.001 0.003 0.37
Crisis -0.047*** 0.003 -17.91
R2 9.31%
No obs. 212,623
Panel A shows the results of the first stage regression of
Equation 3.6 instrumenting BankQuality with the two
exclusionary instruments NBanks and Local. Panel B
shows the results of the second stage regression of Equa-
tion 3.5 answering Hypothesis 1 that high bank quality is
positively associated with high firm performance. Firm
fixed effects, year controls and robust standard errors
clustered by firm. The symbols *, ** and *** denote
significance at the 10%, 5% and 1% levels, respectively.
that they are strong instruments.28 Both instruments are significantly negative.29
This implies that if there are many banks in the firm’s area (NBanks) or if the bank is
located in the vicinity of the firm (Local), the firm is less likely to have a high quality
bank. This makes intuitive sense: If there are many banks to chose between in the
firm’s area, the competition is high and as a result some banks offer more favourable
terms to the firm. These terms are likely to be more important for the firm than
the quality of the bank. Similarly, a firm may value physical proximity of the bank
over the quality of the bank which is not surprising since the firms in the sample are
relatively small and therefore likely to rely on a relation with the bank based on soft
information.
The result of the second stage performance regression, Equation 3.5, is tabulated
in Panel B of Table 3.7 on the previous page. Recall that a positive coefficient was pre-
dicted on BankQuality, implying that high quality banks have customers with higher
performance. However, we cannot maintain H1 since the coefficient on BankQuality
is insignificant and in fact negative. We propose two alternative explanations for this.
First, it may be that bank quality as we measure it, namely a composite measure of
financial stability, CAMELS ratings and accounting quality, inadequately captures a
bank’s monitoring efforts. Second, it could also be that our measure of bank qual-
ity does in fact measure bank monitoring efforts correctly, but that bank monitoring
does not explain the performance of their customers. The banks are only interested
in firm performance indirectly because high performing customers are naturally good
customers, but the main concern for the bank is that the firms are able to meet their
28
This is underlined by the two specification tests, the F-statistic of weak instruments which shows
that the instruments are both jointly and separately (untabulated) significant in explaining the bank-
firm match, and the Sargan-Hansen Test, testing the joint null hypothesis that the instruments are
valid instruments, i.e. uncorrelated with the error term, and that the excluded instruments are cor-
rectly excluded from the estimated equation. The R2 is rather low, however, following (Wooldridge,
2008, p.517) and Pesaran and Smith (1994), the R2 is not very useful in IV regressions since goodness-
of-fit is not a factor and it in fact can be negative.
29
A third instrument measuring the extent to which small (large) banks have small (large) cus-
tomers was jointly, but not separately, significant and was therefore excluded from the model.
Table 3.8: The effect of monitoring on firm performance (H2)
Estimate Estimate Estimate Estimate

(Std.Err.) (Std.Err.) (Std.Err.) (Std.Err.)
BankQuality -0.001 -0.003*** -0.001 -0.001
(0.001) (0.001) (0.001) (0.001)
Dual -0.292*
(0.162)
Dual×BankQuality 0.006*
(0.003)
BigOwn -0.166***
(0.058)
BigOwn×BankQuality 0.003***
(0.001)
Multiple 0.23
(0.155)
Multiple×BankQuality -0.005
(0.003)
∆Auditor 0.082**
(0.038)
∆Auditor×BankQuality -0.002**
(0.001)
FirmSize 0.099*** 0.099*** 0.099*** 0.099***
(0.002) (0.002) (0.002) (0.002)
FirmLeverage 0.001 0.001* 0.001 0.001
(0.001) (0.001) (0.001) (0.001)
FirmGrowth 0.001*** 0.001*** 0.001*** 0.001***
(0.001) (0.001) (0.001) (0.001)
FirmAge 0.001 0.001 0.002 0.002
(0.002) (0.002) (0.002) (0.002)
Crisis -0.047*** -0.048*** -0.046*** -0.047***
(0.003) (0.003) (0.003) (0.003)
F-value: First stage 1 77.29 77.61 82.66 76.36
F-value: First stage 2 7.02 80.93 7.83 78.47
R2 9.02% 8.21% 8.68% 9.07%
No firm-year obs. 212,623 212,623 212,623 211,156
The table shows the results of Equation 3.7 answering Hypothesis 2 that the effect of
bank quality on firm performance is exacerbated by poor alternative monitoring. Firm
fixed effects, year controls and robust standard errors (in parentheses) clustered by firm.
The symbols *, ** and *** denote significance at the 10%, 5% and 1% levels, respectively.
obligations. Therefore, the monitoring of high quality banks may not translate into
higher performance by the corporate customers.
The second stage result of Hypothesis 2 is tabulated in Table 3.8.30 Recall that
30
The two first stage regressions are un-tabulated but are available upon request.
we expect a positive coefficient on the interaction between BankQuality and each

of the four proxies for monitoring, implying that the effect of bank quality on firm
performance is boosted when alternative monitoring is weak.
The analyses do indeed show that firms with CEO/chair duality have a signifi-
cantly negative return on assets (an estimate of -0.292), but as the bank quality of
these firms increases, the performance also increases (significantly positive coefficient
on Dual×BankQuality). For firms with a big owner (i.e. share above 50%) we see the
same significant effect in the form of a positive relation between bank quality and firm
performance. It should, however, be noted that BankQuality is significantly negative
suggesting that firms without one large owner, i.e. with a more dispersed ownership
structure, have decreasing performance with increasing bank quality. We find no sig-
nificant results in the analysis of bank multiplicity. This is probably caused by the
characteristics of the firms with multiple banks which are found to be much larger and
better performing (see Table 3.4), hence, they will not derive additional benefit from
having a high quality bank. Our last proxy for poor alternative monitoring, a change
of auditor, interestingly yields a result that is directly contrary to our expectations.
The higher the quality of their bank relation, the lower the performance of the firms
with change of auditor. This indicates, that high quality banks punish those corpo-
rate customers that change auditor, hence, the negative signal of auditor changes is
reflected in firm profitability.
Overall, our results show that there is a substitution effect between firms’ alterna-
tive monitoring (measured by CEO/chair duality and the ownership structure of the
firm) and the monitoring role of the bank. If a firm has weak alternative monitoring,
then the firm benefits, in terms of performance, from having a high quality bank.
However, the signalling effect of changing the auditor is perceived to be more of a
problem from the point of view of a high quality bank and this is reflected in lower
performance of those firms.
3.5. Conclusion 107
3.5 Conclusion
This paper examines the spill-over effect of banks on their corporate customers, in
particular the way in which the bank’s own quality influences first, the performance
of its customers and second, the substitution effect of bank monitoring when firms’
alternative monitoring is weak. We exploit unique Danish data that links each bank
to its corporate customers to observe this mechanism.
We cannot document a correlation between bank quality and the performance of
the corporate customers per se. This could either be because our measure of bank
quality inadequately captures bank monitoring effects or because bank monitoring does
not have direct output effects on the customers. However, these monitoring effects
become evident when alternative monitoring mechanisms are weak (measured with
CEO/chair duality and ownership structure), indicating that there is a substitution
effect between firms’ alternative monitoring and the monitoring performed by high
quality banks.
The findings in this paper are of particular interest for bank regulators as it demon-
strates a real effect on bank customers from the financial statement numbers used for
bank regulation (e.g., capital and liquidity ratios).
Our inability to find a statistically significant relation between bank monitoring and
firm performance, measured by return on assets, might be due to a situation where the
banks focus their interest on outcomes other than pure performance when monitoring
customers. As debt holders, banks are more concerned about a firm meeting its
obligations and not defaulting rather than about the performance. It would therefore
be quite interesting to test if bank quality explains other firm characteristics such as
repayment ability or default probability. We leave these issues for future studies.
Appendix A
Data Description and the Sorting Process
This chapter describes the sorting of the Experian data. First, I present the raw
dataset and in Section A.2, I document the process of creating the final dataset. The
data contains annual extracts of the population of Danish firms and consists of the
following nine datasets: master data, industry, name of the firm, financial statements,
bank connection, ownership information, the role of individuals and the auditor. These
datasets are linked using unique firm ID numbers and person specific ID numbers.1
A.1 The Dataset
A.1.1 Master Data
This dataset includes the address of the firm, date of registration at the Danish Busi-
ness Authority (Erhvervsstyrelsen), the status of the firm (active, inactive, closed
down or shell company), the legal form of the firm (e.g. stock company, limited li-
1
These ID numbers are Specific to the Experian data.
110 Appendix A. Data Description and the Sorting Process
ability company, co-operative) and the company registration number at the Danish
Central Business Register (CVR nr).
A.1.2 Industry
The dataset includes the industry code(s) of each specific firm. Each firm may have
a number of industry codes in each year in which case the first code is used for the
sorting. In 2008, the industrial classification codes are changed (for example, the code
for banks changes from 65120000 to 6419000 and the code for auditor changes from
74120000 to 69200000). This is of course controlled for in the industry classification.
The industry classification is based on the groupings used by Statistics Denmark
(similar to the European classification NACE rev. 1 before 2008 and NACE rev. 2
from 2008). I construct ten industry classification indicators equal to 1 if the firm
belongs to one of the following groupings, 0 otherwise
• Industry 1: Agriculture/forestry/fishing
• Industry 2: Manufacturing/mining and quarrying
• Industry 3: Construction
• Industry 4: Trade/transport
• Industry 5: Information/communication
• Industry 6: Financial/insurance
• Industry 7: Real estate
• Industry 8: Other business (knowledge-based)
• Industry 9: Public administration/education/health
• Industry 10: Arts/entertainment/other services

A.1. The Dataset 111
Some firms have had a specific industry code from 2000 to 2007, and then after
the change 2008, the industry code is set to missing (i.e. 99999900). Naturally, I
cannot use the same industry code in 2008 as in 2007 because of the change, but if
the specific firm was categorized as Industry 3 before 2008, I assume that this firm is
still in construction and change the industry classification indicator Industry 3 to 1.
Some firms change their industry classification over time. If this change is caused
by a change in the order of the industry codes, then this is controlled for such that the
firm does not change industry classification. This is of course only the case for firms
with multiple industry codes available (6.9% of the firm-year observations include
multiple industry codes). Only the first three industry codes are considered (only
0.2% of the observations have more than three industry codes available).
If information on a company is missing for a period of no more than three years
and if that company has the same classification before and after the years of no
information, I assume that the firm has remained in the same industry during the
years of no information.
A.1.3 Name
The name of the firm can either be a main name, a secondary name, a name the firm
goes by, a former name or a name that is under revision. I keep only the main name
and either the secondary name or the name, that the firm goes by, if available.
A.1.4 Financial Statements
Each yearly dataset includes present and historical financial statements. I only keep
financial statements from 1999 and onwards. The data includes unconsolidated as
well as consolidated statements (if available). The data is stated at a rather aggregate
level which reflects the existence of many small firms in the sample (i.e. more basic
requirements for the content of the financial statements).
Table A.1: Available information from income statements

Income statement
Net turnover
Gross profit
Employee expenses
Depreciation
Earnings before interest & taxes
Financial income
Financial expenses
Net financial income/expenses
Earnings before taxes & extraordinary items
Extraordinary items
Earnings before taxes
Net profit/loss
Dividends
Table A.2: Available information from the balance sheet

Assets Liabilities
Non-current assets Equity
Intangible assets Share capital
Tangible assets Reserves
Property, plant & equipment Provisions
Financial assets Subordinated loans
Current assets Long term debt
Inventories Mortgage loans
Receivables Short term debt
Cash Payables
A.1.5 Bank Connection
The data reveals the name(s) of the firm’s bank connection(s). If the firm has multiple
banks, they are listed one after another. The dataset is transformed into a firm-year
panel by extracting additional bank names and labelling them bank1, bank2 etc. The
bank names can be spelled differently over time, also for each individual firm, hence,
this will naturally be controlled for in the sorting process.
A.1. The Dataset 113
A.1.6 Owners
This dataset includes present and former owners. I only keep the information relevant
in each year (i.e. in the 2010 data I only include those that are still owners in 2010).
The data includes the firm specific ID number, the ID number of the company that
owns the firm, ID numbers of individuals who are owners, the percentage ownership
share, the ownership role (i.e. associated company, mother company, shareholder),
name and country of the owner.
A.1.7 The Role of Individuals
This dataset includes the specific role of individuals (ID codes on individuals) for each
firm. The data also includes persons who had a role in the firm in the past, but I have
excluded those in the yearly dataset (i.e. in 2008, I am only interested in people who
still play a role in the firm in 2008). The roles could be, for example, CEO, CFO,
head of accounting, marketing, production etc.
A.1.8 Auditor
The dataset includes all auditors meaning that it might also include auditors who are
no longer active for the firm (for each year, I only include the auditors who are active
in that specific year). A firm might have multiple auditors (or advisors) and may
replace its auditor several times during one year (hence, this is not a panel with only
one firm-year observation). The dataset includes the name of the auditor and/or an
ID number. In case of no information on name, I match the dataset with the dataset
on firm names and industries and thereby I can leave out those where I cannot confirm
that the company in question is an auditor (either by means of industry code (74120000
or 69200000) or the word “revision”/”revisor” in the company name). The reason for
this procedure is that the firms may have stated an advisor in stead of/along with
the auditor. An additional match was made with a sample of firms with their main
activity categorised as Auditor from the Danish Central Business Register available
from the Danish Business Authority.2
A.2 Data Sorting

This section elaborates on the data sorting process. Only the sorting of datasets that
are relevant for the analyses related to the PhD thesis is presented. The primary data
of interest is the firm’s bank connection, hence, this needs to be available for the firms
that are included in the final dataset.
A.2.1 Bank Connection
The bank information provides a bank name for the individual firm in each year. in-
formation is missing for one or more years, then if the same bank name appears before
and after the gap and the period with no information does not exceed three years,
I assume that the firm also had the same bank in the years of missing information.
Bank names can be spelled differently over time and by different firms, hence, I also
change the bank names such that they only appear in one version, e.g. "Nordea Bank
Danmark" and "Nordea Danmark" both appear in the original data. A number of
banks also change their name during the period of analysis. In that case, I change all
previous bank names to the new name so they do not show up as a change of bank. A
bank change variable is constructed which is equal to 1 if the firm changes the bank,
0 otherwise. If there are years of missing information and the firm has Bank A before
the gap and then Bank B, the bank change variable does not change to 1 because I do
not know the exact year of the change. If a firm has multiple banks, I construct an
indicator variable MultBank equal to 1, and 0 if the firm has a single bank connection.
I have a separate datafile with the bank merger information.3 The month in which
2
Available at http://datacvr.virk.dk/data/
3
This dataset is hand-collected and not part of the data from Experian.
A.2. Data Sorting 115
the merger took place is usually specified. I assume that this information should be
available by the date of the annual financial statement of the firm. If a firm changes
bank because of a bank merger, then the bank change variable is changed to 0 such
that only non-merger related changes (and changes not related to bank bankruptcies)
are reflected in the bank change variable. See the description of the bank merger data
in Section A.3.
A.2.2 Financial Statements
The dataset only includes firms with bank information at some time between 2000 and
2011, and the dataset is then sorted in the following way. There are 889,488 firm-year
observations with bank information as well as financial statements and the sorting is
based on firm-years.
• Financial institutions are excluded from the dataset (128,736 out of 889,488
observations). Financial institutions are classified as Industry8 and includes for
example banks, financial holding companies, investment funds, venture capital
funds, mortgage institutions and insurance companies.
• Utility firms (el-, gas- og fjernvarmeforsyning) are excluded because their finan-
cial statements tend to be different than those from other companies (2,061 out
of 760,752 observations).
• Only private limited companies that are required to report after Danish GAAP
are included in the dataset (in Danish: aktieselskaber, anpartsselskaber, andels-
selskaber med begrænset ansvar, erhvervsdrivende fonde and kommanditaktiesel-
skaber). This means that for example shell companies, sole proprietorships,
cooperatives with unlimited liabilities and foreign limited companies are left out
(13,314 out of 758,691 observations).
• If information on total assets is missing, the observation is deleted (2,320 obser-

vations out of 745,377).
• If the sum of non-current assets and current assets is ± 1 of total assets and if
the sum of equity, provisions, subordinated loans, long term and short term debt
is ± 1 of total assets, then the observation is deleted (2,105 observations out of
743,057). I hereby only allow for rounding errors. The financial statements are
most frequently in real numbers (i.e. 0 in nomination) whereas Experian has
changed the nomination to 3, i.e. in thousands. This results in many rounding
errors of ± 1 in the dataset.
• I suspect errors in case of negative values in net sales, fixed assets, intangible as-
sets, PPE, financial assets, current assets, inventories or receivables. Firm-year
observations with suspected errors are deleted (1,768 out of 740,952 observa-
tions).
• Some firms have multiple financial statements in the same year, for example,
caused by changes in the fiscal year. In that case, the statement containing the
largest number of months is kept (7,468 out of 739,184 observations are deleted).
• Some firms have financial statements that report zero months. These are man-
ually checked for mistakes, but are otherwise deleted from the sample (9 out of
731,716 observations are deleted). Statements reporting zero months are most
often found when the company is set up or closed.
• For those statements with number of months not equal to 12 months, for example
caused by changes in fiscal year, I scale the flow variables accordingly.
• Firms reporting in foreign currency are deleted because the calculated variables
are not comparable if the currency differs (1,920 out of 731,707 observations are
deleted).
• Observations with financial statements presented in actual values (0 in nomina-

tion) or in millions (6 in nomination) are re-calculated such that all values are
reported in thousands DKK.
• Some firms in the dataset are stated to be parent companies.4 In such cases,
the bank will primarily be interested in the consolidated financial statement as
this forms the basis for e.g. a loan grant to either the parent or the subsidiary
company and the collateral will usually be provided by the group enterprise such
that all firms in the group provide security for each other. In case only the parent
firm is available in the dataset and both the consolidated and the unconsolidated
financial statements are available, I therefore use the consolidated statement in
the analyses (14,988 observations out of 729,787 are deleted).
In case there are several financial statements available from firms that are part
of the same group, I use the following selection criteria:5
– If the subsidiary(subsidiaries) has (have) the same bank(s) as the parent

company, I use the consolidated financial statement and delete the individ-
ual financial statements of the parent as well as of the subsidiaries in the
sample (364 out of 714,799 observations are deleted).
– If the subsidiaries have the same bank(s) as the parent company, but no
consolidated financial statement is available in the dataset, I do the follow-
ing:
∗ If total assets of the parent firm are higher than for the assets of the
subsidiaries, I use the financial statement of the parent and delete
the subsidiaries from the sample (873 out of 714,435 observations are
deleted).
4
Only firms that are stated to be "Parent" and those with more than 50% ownership are consid-
ered.
5
The sorting is based on the advice given in a telephone interview with Tom Jensen, Head of
Strategy & Development at Jyske Bank.
∗ If total assets of the subsidiary are higher than in the parent com-
pany, I use the subsidiary’s financial statement and delete the parent
from the sample because this indicates that the main activities are
placed in the subsidiary.6 If there are several subsidiaries (with the
same bank connection as the parent), I create a consolidated state-
ment. This results in the deletion of 531 observations from parent
firms and 2,049 observations from subsidiaries out of 713,562 and the
addition of 2,033 firm-year observations containing new consolidated
financial statements.
– If the subsidiary has a different bank(s) than the parent company, I use
the individual financial statements of both the parent and the subsidiary
and delete the consolidated statement (129 out of 713,015 observations are
deleted.)
– If there are multiple consolidated financial statements available within the

same group (i.e. one for A+B+C and one for B+C), then only if the two
consolidated statements have different bank connections do I include both.
Otherwise, I delete the consolidated statement for the group B+C (102 out
of 712,886 observations are deleted).
– After the sorting above, the dataset still includes 10,695 duplicates with
respect to firm ID and year, i.e firms with both consolidated and uncon-
solidated statements available. The reason is lack of information for the
sorting process which is performed at a firm-year level since the ownership
of firms is likely to change over the years. Since consolidated statements
are most important for the bank in the process of granting loans, I keep the
consolidated statements and delete the 10,695 unconsolidated statements
6
This would most likely be the case for holding companies where the parent in reality is more or
less empty apart from holding the investment in the subsidiary. Therefore, the available information
in such a consolidated statement is scarce.
out of 712,784 observations.
• Listed firms are excluded. If the firm becomes listed during the period, only
the years after the date of IPO are deleted (1,297 firm-year observations out of
702,089 are deleted). Listed firms are excluded because they have other financing
alternatives than bank loans and hence they are not as bank dependent as SMEs.
• Large firms are excluded based on total assets (firms with more than DKK 119
mill. in years 2000-2008 and more than DKK 143 mill. in 2009-2011).7 Only
firms that are defined large in two subsequent years are deleted, hence a firm can
exceed the limit for one year if it is under the limit the year after (23,866 out of
700,792 observations). I focus on SMEs in the study because these companies
are more bank dependent than large firms.
• Small firms with less than e 100,000 (DKK 750,000) in total assets in two
subsequent years are deleted (102,106 out of 676,926 observations). These small
firms are excluded because the information level in the financial statements from
such very small firms is very low.
• If the fiscal year of the financial statement overlaps the calendar year, then the
financial statement is included in the latest calender year. For example, if a firm
has fiscal year from April 2007 to end March 2008, then the financial statement
is included in the 2008 calendar year.
• Some firms have written "-" in the expense items where other firms have not.
This has been changed to "+".
7
According to Danish GAAP, large firms are defined as exceeding two out of three of the following
criteria for two subsequent years, namely gross profit DKK 286 mio., total assets of DKK 143 mio.
or 250 employees from 2009. Because of data limitations, I only define large firms based on total
assets.
Table A.3: Sample selection from financial statements
Selection criteria Firm-year obs.

Less 13,314 non private limited firms 745,377
Less 2,105 obs. with unequal assets and liabilities 740,952
Less 1,768 obs. with suspected errors 739,184
Less 29,731 parent or subsidiary obs. plus 2,033 new obs. 702,089
Less 1,297 listed firm-year obs. 700,792
Less 23,866 obs. of large firms 676,926
Less 102,106 obs. of small firms 574,820
Final sample containing financial statements 574,820
The table presents an overview of the sorting process. Please note that this
is the exact sorting used in Chapter 2 in the dissertation whereas Chapter 3
is slightly different (see Table 3.1).
A.2.3 Owners
The percentage share of ownership is known in separate years, hence, the ownership
information is not a firm-year panel because there are often multiple owners for a
specific firm in each year. The percentage of ownership ranges from 0 to 100. I
have constructed an ownership variable using an approach inspired by the ownership
categorisation in Orbis from Bureau van Dijk. For each firm in each year, I construct
three categories: A indicates that no owner has more than 25% ownership, B indicates
that the largest owner of the firm holds between 25% and 50% and C indicates that
one of the owners holds more than a 50% ownership share. In case there are gaps
in the ownership information, and this gap is no more than three years and if the
firm has the same ownership category before and after the gap, I fill out the years of
missing information.
A.2.4 The Role of Individuals
In relation to the monitoring mechanism of firms, which is analysed in the third paper
in this dissertation, I only focus on the following roles: CEO, assistant CEO, member
of the board and chairman of the board. For each firm in each year, I count the number
of persons with each of these roles, and next, I construct new variables linking the two
types of board members with the CEO/assistant CEO, i.e. an interaction between
the role in the board and CEO/assistant CEO for each specific person. Hence, this
is actually a count function for the number of people having multiple roles in each
specific firm in each year.
A.2.5 Auditor
I construct an indicator variable of 1 if the firm has an auditor (either I know the
industry code or the name of the auditor), 0 otherwise. In 2008, there is a change
in Danish industry codes (the change to Nace rev. 2) resulting in a lot of missing
information (industry code is set to 99999900). Because of this, the Auditor indicator
naturally changes to 0 in case the industry code cannot confirm that the company
mentioned is in fact an auditor. If the firm has an auditor (classified by industry code
74120000) in 2007 and the ID or the name of the auditor is the same in 2008 (but the
industry code has changed to 99999900, hence the Auditor indicator is equal to 0),
I assume that this is still an auditor in 2008 and therefore set the Auditor indicator
equal to 1. Additionally, I have constructed an indicator variable of 1 if the firm has
a Big 4 auditor (if the name includes either Waterhouse, PWC, Deloitte, KPMG or
Young), 0 otherwise. Since many firms in the sample only have a firm ID on their
auditor and not the name, I have cross-checked the information such that the ID of a
Big 4 auditor (where I know both the name and the ID) is matched with those firms
without an auditor name.
Some firms have multiple auditors and/or they can change auditor(s). In order to
create a firm-year panel dataset, I construct an indicator variable, MultAud, of 1 if

the firm has multiple auditors, 0 otherwise. Also, I construct an indicator variable of
1 if the firm has changed the auditor, AudChange, 0 otherwise. The same auditor can
be spelled in different ways over time, hence, I control for this when constructing the
AudChange variable. The AudChange indicator captures any changes in the auditor
for each specific firm. This change may, however, also be caused be mergers between
auditors which I cannot control for., i.e. if the firm is a customer with the target
auditor, the result will be that the AudChange indicator equals 1. However, if the
firm changes the auditor, but the address of the auditor is the same as the year
before, I set the AudChange variable equal to 0.
A.3 Bank Merger Information

The information on bank mergers and acquisitions has been extracted from the Danish
Bankers Association (Finansrådet), Orbis (Bureau van Dijk) and/or the homepage of
individual banks. The distinction between mergers and acquisitions is based on the
exact wording from the different sources of information. This is, however, not found to
be very reliable,8 and therefore I do not differentiate between mergers and acquisitions
in the analyses.9 I have also collected information on name changes during the period
of analyses since this of course should not be reflected as a change of bank for the
individual firm.
The information on bank mergers has been linked with the bank connection in-
formation which is available at firm level. If the firm is a customer in a bank that
consolidates, then I construct an indicator variable of 1 in all years for this specific
8
The consolidation of Sydbank and Egnsbank Fyn in 2002 is labelled as a merger, but since
Sydbank is one of the largest banks in Denmark, it is more likely that Sydbank actually acquired
Egnsbank Fyn. The same is the case with the so-called merger between Nykredit and Forstædernes
Bank in 2010. Additionally, several consolidations between two smaller banks are labelled as acqui-
sitions, but the new consolidated bank takes a new name which is a combination between the two.
Therefore, these are probably mergers and not acquisitions.
9
Analyses differentiating between the two provide no significant results.
A.3. Bank Merger Information 123
Treatment firm, 0 otherwise. Additionally, I construct an indicator variable of 1 in the

full post merger period, Post, and 0 otherwise (i.e. the pre merger period). I assume,
that the bank merger should be known by the date of the fiscal year. For example,
in February 2003 Vestjysk Bank merged with Nordvestbank and continued under the
name Vestjysk Bank. If the firm has Nordvestbank as the bank connection up to 2002
and then changes to Vestjysk Bank (or another bank), then I set the Post indicator
equal to 1 from 2003 if the firm’s fiscal year ends before February 2003. If the fiscal
year of the financial statement ends in February or later, I set the Post indicator equal
to 1 from 2004. Only firms that are customers in Nordvestbank (the target bank) are
stated as being subject to the merger.
Another example is found when two banks are consolidating and the bank takes on
a new name after the merger. In that case, I manually go through publicly available
information and press releases to verify if this is indeed a merger between the two,
or if one bank is stronger than the other. If one bank in effect is the stronger one, I
only label firms that are customers in the target bank (the weak bank) to be exposed
to the merger, i.e. a treatment firm. If this is a merger between two equally strong
banks, the firms being customers in either one of the two banks are labelled as being
subject to the merger. In the analyses, the important question is the credit policy
of the bank when granting loans to corporate customers. Therefore, the intuition is
that a merger between a strong and a weak bank will result in a change in the credit
policy of the weak bank whereas if the merger is equal, the new consolidated bank
may use either one of the former banks’ credit policies. Hence, I assume that when
Bank A and Bank B merge under the name Bank A, then the credit policy of Bank
A is the dominant one and therefore it is the customers of Bank B who are exposed
to changes. Alternatively, if Bank A and Bank B merge into Bank C, then if Bank
A is the stronger one, only firms who are customers in Bank B are exposed to the
merger or if the two banks are equal (no public information states otherwise), then the
corporate customers of both banks are considered to be affected by the bank merger.
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2015-15

Lene Gilje Justesen

DEPARTMENT OF ECONOMICS AND BUSINESS

Lene Gilje Justesen

A PhD thesis submitted to the School of Business and Social Sciences,

Chapter 1 Deposit Insurance and Risk Shifting in a

Chapter 3 The Effect of Bank Quality on Corporate Customers 75

Appendix A Data Description and the Sorting Process 109

In this empirical thesis, I study the importance of bank-firm relationships on credit

One of the primary roles of banks is to serve as financial intermediaries by transfer-

Lene Gilje Justesen

In Chapter 1 we provide empirical evidence on the moral hazard implications of in-

I Kapitel 1 præsenterer vi empirisk evidens på, hvordan indskydergaranti påvirker

Vi benytter et forskningsdesign baseret på forskelle mellem to grupper til at vise, at

Kapitel 2 analyserer, om virksomhederne oplever kreditklemmer, når deres bank

Ved hjælp af et stort dansk datasæt undersøger jeg, hvordan banksammenlægninger

Deposit Insurance and Risk Shifting in a

Jan Bartholdy and Lene Gilje Justesen

Department of Economics and Business Economics

This study provides empirical evidence on the moral hazard implications

Keywords: Deposit insurance, asymmetric information, moral hazard.

JEL Classification: G21.

1.2 Literature Review and Hypothesis

1.2.1 The Institutional Setting in Denmark

1.2.2 Ownership Structure

1.2.3 Capital Requirements and Closure Policy

In a perfect regulatory system with no asymmetric information, with continuous mo-

Commercial banks Savings banks

1.3.1 Measures of Bank Risk

Distressit =β0 + β1 lnT Ait−1 + β2 ROAit−1 + β3 U nempt−1 + β4 N BRatet−1 +

Where Distress is a binary variable of 1 if the bank is in financial distress, 0 other-

Table 1.4: Estimation of risk proxies

Risk variable Full sample Large banks Small banks

sign of risky behaviour because increased investments in risky projects results in an

Specifically, we estimate the following logistic regression (similar to Equation 1.1).

Distressit =β0 + β1 lnT Ait−1 + β2 ROAit−1 + β3 U nempt−1 + β4 N BRatet−1 +

Table 1.5: Estimation of the aggregate risk model

Estimate Std. Error Wald stat.

Table 1.6: Average D-scores

Group Obs. Mean Std. dev.

1.4 Research Design

Riskit =β0 + β1 P ostit + β2 Bankit + β3 P ostit × Bankit + β 0 Xt + it (1.5)

where β1 =(Risk Savings

Impact on Commercial banks Savings banks

From a regulatory point of view, we are especially interested in testing if the

of 0.104 higher bond to asset ratio).

Table 1.9: The effect of deposit insurance on D-scores

Full sample Large banks Small banks

The difference-in-difference analysis based on the composite measure of risk, the

1.6 Controlling for Possible Endogeneity

Bankit =β0 + β1 Branchi,1982 + β2 Growthi,1982 + β3 lnT Ai,1982 +

Table 1.10: First stage regression

Coefficient Std.Err T value

Table 1.11: The effect on risk: difference-in-difference estimates

Full sample Large banks Small banks

Table 1.12: The effect of deposit insurance on the D-score

Full sample Large banks Small banks

1.7 Robustness Check

Riskit =β0 + β1 P ostit + β2 Bankit + β3 P ostit × Bankit + β 0 Xt + it (1.5)

β8 Growthit + β9 N egEqit + β10 lnAgeit + it

β7 Growthit + β8 N egEqit + β9 lnAgeit + it