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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 targetAffected by
• shareholders limited liability
- gambling for resurrection
• expectations of support
• sub-contract monitoring to regulators
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Affected by
• deposit protection arrangements
• too big to fail
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
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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
Safety net 1 if public support rating = 1 or 2
0 = 3, 4, 5
(2) Government support
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(3) Uninsured Deposits
Proportion of uninsured interbank deposits
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(4) Disclosure
Bank’s risk profile - interest rate risk
- credit risk
- liquidity risk
- market riskCapital and reserves
Constructed an index on core
disclosure items from BankScope
18 categories covering following areas -
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(5) US listing
NYSE, NASDAC or AMEX
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ititititit υ)Z,MKD,f(RISKCAP
Risk - components of weekly equity returns- one period ahead loan loss provisions
Z - control variables - return on equity- log of total assets- GDP growth
MKD - market disclosure/market discipline variables
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Deposit insurance and support: negative Interbank deposits:
positive
US listing and disclosure index: positive
Results- effect on capital relative to risk
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Table 1[495]:The effect of market discipline on bank capital
(1) (2) (3)Dependentvariable
Cap Cap Cap
Constant -3.2609*** -1.9414*** -3.0638***Provisions (t+1) 0.3657*** -0.1016*** -0.0320**Beta 0.0044*** 0.0070*** 0.0068***Idios. Risk -0.1715*** -0.0537*** -0.0427***Logsize -0.0043*** -0.0138*** -0.0147***Roe 0.0535*** 0.0217*** 0.0247***GDP growth 0.0058 -0.1154*** -0.1244***Non-perf. Loans -0.0970*** 0.0016 0.0075Market share -0.0484*** 0.0394*** 0.0282***Cap. Req. 0.0148*** 0.0115*** 0.0122***Time trend 0.0016*** 0.0011*** 0.0016***Dep. Insurance -0.0023*** -0.0065*** -0.0059***Support -0.0117***Bank deposits 0.0676*** 0.0784***Rating 0.0030*** 0.0031***Listing 0.0098*** 0.0149***Disclosure 0.0157*** 0.0147***No. of obs. 695 726 728No. of banks 154 199 199Goodness of fit 0.50 0.46 0.46Log likelihood 2424 2694 2732
Source: Bank calculations.
* Indicates significance at the 10 % level.** Indicates significance at the 5 % level.*** Indicates significance at the 1 % level.
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Effect on capital for given riskBanks 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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Crisis=f (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
Lloyds HSBC AbbeyStandardChartered Barclays
95%,1 day
99%,10 days
95%,1 day
97.5%,> 1 day
98%,1 day
- comparable disclosure important
VaR
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Pillar III will be effective in increasing amount of comparable disclosure
Important for standardised and IRB banks.