6th June 2003 1

Market Discipline -Effect on Bank Risk Taking

Glenn Hoggarth

Patricia Jackson

Erlend Nier

6th June 2003 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

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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.