Market Discipline -Effect on Bank Risk Taking

1. Market Discipline -Effect on Bank Risk Taking Glenn Hoggarth Patricia Jackson Erlend Nier

2. 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

3. 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

4. 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

5. 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

6. Equity market -cost and availability of new capital - takeover target A number of markets likely to discipline banks- main ones • Affected by • shareholders limited liability • - gambling for resurrection • expectations of support • sub-contract monitoring to regulators

7. 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

8. 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

9. (1) Effect on banks’ capital (resilience to shocks)

10. 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

11. Identified measures of the strength of market discipline

12. (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

13. Fitch (2) Government support

14. (3) Uninsured Deposits Proportion of uninsured interbank deposits

15. (4) Disclosure Constructed an index on core disclosure items from BankScope 18 categories covering following areas -

16. (5) US listingNYSE, NASDAC or AMEX

18. Results- effect on capital relative to risk Deposit insurance and support: negative Interbank deposits: positive US listing and disclosure index: positive

20. Effect on capitalfor 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.

21. 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?

22. (2) Effect on the likelihood of banking crises

23. 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.

24. 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.

25. Market discipline variables • Deposit protection • Government support • Disclosure • US listing

26. 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

27. 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

28. 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

29. 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

30. 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.

31. 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 ?

32. (3) Effect on costs of crisis resolution

33. 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

34. 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

35. (4) Implications for public policy

36. Deposit Insurance • Explicit deposit insurance may prevent banking crises • unlimited deposit protection schemes could be harmful -affect bank behaviour make crises more likely

37. 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

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

39. Nature of disclosure - comparable disclosure important VaR

40. Pillar III will be effective in increasing amount of comparable disclosureImportant for standardised and IRB banks.