Market Discipline -Effect on Bank Risk Taking

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Market Discipline -Effect on Bank Risk Taking

• Glenn Hoggarth
• Patricia Jackson
• Erlend Nier

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Market discipline

• Policy initiatives (eg Basel II) recognize
  importance for financial stability
• Pillar III of Basel II attempts to strengthen
  market discipline by requiring disclosure
• Greater disclosure is being resisted by banks
  -argue costs outweigh benefits
• Hardly any evidence on effectiveness of
  disclosure and market discipline

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Policy Basel Committee

• Basel I - Created common metric for measuring
  capital relative to risk - Risk asset ratio - but
  some banks only publish Tier1 plus Tier 2
• Basel II- Pillar III -minimum standards pf
  disclosure -covering composition of capital and
  risks

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Evidence that market discipline may affect bank
behavior

• Important to consider whether there would be
  benefits to financial stability from greater
  market discipline
• Or are banks right -and benefits not enough to
  outweigh costs
• First need to consider conditions for effective
  market discipline

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Concepts Effective market discipline

• Market must have information to assess riskiness
  of banks
• importance of disclosure
• Market participants must be at risk of loss
• importance of limited safety net

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A number of markets likely to discipline banks-
main ones

• Equity market

• - cost and availability of new capital
• - takeover target

• Affected by
• shareholders limited liability
• - gambling for resurrection
• expectations of support
• sub-contract monitoring to regulators

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Interbank market
- cost and availability of short-term funding -
ability to hedge risks in OTC derivatives
markets, eg swaps, essential - graduated reaction
more likely from wholesale counterparties

• Affected by
• deposit protection arrangements
• too big to fail

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Assemble evidence related three questions

• (1) Does market discipline affect the size of
  bank capital buffers (resilience to shocks)
• (2) Does market discipline affect the likelihood
  of crises
• (3) Does market discipline affect costs of crisis
  resolution

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(1) Effect on banks capital (resilience to
shocks)
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• Bank of England research, Market Discipline,
  Disclosure and Moral Hazard in Banking, (Nier
  and Baumann) tested the effect of disclosure and
  the safety net on individual banks capital
  buffers
• cross country panel dataset
• 729 individual banks from 32 countries
• typically observations from 1993 to 2000

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Identified measures of the strength of market
discipline
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(1) Depositor protection

• Index on existence and extent
• Depins 2 1 or 0 - if schemes exist
• Depins 3 1 or 0 - no co-insurance
• Depins 4 1 or 0 - interbank deposits covered
• Depins 5 1 or 0 - unlimited coverage
• Depins sum of depins 2, depins 3, depins 4,
  depins 5

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Fitch
(2) Government support
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(3) Uninsured Deposits
Proportion of uninsured interbank deposits
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(4) Disclosure
Constructed an index on core disclosure items
from BankScope 18 categories covering following
areas -
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(5) US listingNYSE, NASDAC or AMEX
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Deposit insurance and support negative
Results- effect on capital relative to risk

• Interbank deposits
• positive
• US listing and disclosure index positive

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Effect on capital for given risk

• Banks expected to have government support have a
  capital ratio 1.2 percentage points lower than
  those without.
• Banks fully funded from uninsured interbank
  deposits would have have a capital ratio 7
  percentage points higher than a bank fully funded
  from insured deposits
• Banks disclosing none of the core information
  measured have a capital ratio 1.5 percentage
  points lower than those that do.

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• Findings lend weight to assertion that market
  discipline could help strengthen the financial
  system by increasing resilience to shocks.
• But is there any more direct evidence?

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(2) Effect on the likelihood of banking crises
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• Factors increasing market discipline -
  disclosure- should reduce likelihood of crises
• Factors reducing market discipline (government
  support, deposit protection schemes) could have
  two opposing effects
• -(a) reduce market discipline weakening
  banking system but (b) prevent crisis from
  materialising.

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Empirical approach

• Baumann Nier Data-set
• 32 countries 1993-2000
• 7 banking crises starting /continuing after 1993
• -Korea, Thailand, Indonesia, Malaysia , Japan,
  Turkey and Argentina.

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Market discipline variables

• Deposit protection
• Government support
• Disclosure
• US listing

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Crisisf (MKD,Z)e

• Crisis country dummy value 1 (crisis) 0 not
• Simple OLS regressions of crisis dummy on market
  discipline variables
• Probit regressions of crisis dummy on market
  discipline and control variables

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Results- effect on likelihood of banking crisis

• Disclosure and US listing - weak negative effect,
  appear to reduce likelihood of crisis
• government support - significantly negative
  effect, clearly reduces likelihood of systemic
  crises
• deposit insurance - weak positive effect, appears
  to increase likelihood of crises

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Effect of components of deposit insurance

• Existence of scheme -negative effect, reduces
  likelihood of crisis
• interbank and coinsurane - no evidence either way
• unlimited deposit protection - strong positive
  effect, increases likelihood of crisis

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Probit regressions

• With control variables
• - GDP per capita
• - GDP growth
• market discipline variables retain sign.
• With current account deficit /surplus added
  market discipline variables again retain sign

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Caveat preliminary work

• Small sample of crisis countries
• Will go on to look at effects at bank level -fall
  in capital indicator of problems.
• But does indicate countries should question role
  of unlimited deposit protection schemes and
  should encourage greater disclosure.

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But deposit protection is there to deal with
crisis

• Countries concerned about future potential crises
  will not change procedures if they would damage
  ability to deal with banking problems.
• Further question therefore - do unlimited deposit
  protection schemes improve crisis management ?

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(3) Effect on costs of crisis resolution
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Effect on resolution costs

• Sample of 33 systemic banking crises
• Effect of blanket guarantees
• Effect of depositor protection
• 1 if limited scheme exists
• 0 if scheme is unlimited or does not
  exist
• regressions attempt to control for size of shock,
  eg dummy for currency crisis

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Results- effect on resolution cost

• Blanket Government guarantees appear to increase
  resolution costs
• Limited deposit insurance schemes reduce
  resolution costs - when compared to unlimited or
  implicit schemes

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(4) Implications for public policy
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• Deposit Insurance
• Explicit deposit insurance may prevent banking
  crises
• unlimited deposit protection schemes could be
  harmful -affect bank behaviour make crises more
  likely

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• Implicit government support
• Support prevents crises from materialising (if
  support is credible in fiscal terms)
• Support increases moral hazard and reduces
  resilience of the banking system
• Where support arrangements substantial - more
  onus on supervisors

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• Disclosure
• More information disclosure has the potential to
  strengthen the resilience of the banking system
• Key is comparability of information across banks

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Nature of disclosure
- comparable disclosure important VaR
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Pillar III will be effective in increasing
amount of comparable disclosureImportant for
standardised and IRB banks.