Bank Fundamentals, Bank Bank Fundamentals, Bank Failures, and Market DisciplineFailures, and Market Discipline

by Marco Arenaby Marco Arena

Sergio Schmukler World Bank

First WorkshopLatin American Finance Network

December 11-12, 2003

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OutlineOutline

1. Bank failures and market discipline

2. Market discipline: concept and use

3. Market discipline: existing literature

4. Contribution of the paper

5. Comments on the paper

6. Market discipline in emerging economies

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1.1. Bank failures and market disciplineBank failures and market disciplineScope of the paperScope of the paper

Question 1:

To what extent can we explain cross-country differences in crisis outcomes by appealing to ex-ante cross-country differences in micro level bank fundamentals?

Question 2:

Do depositors in crisis countries discipline riskier banks by withdrawing their deposits and/or by requiring higher interest rates in such a way that deposit withdrawals could be considered an act of market discipline?

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1.1. Bank failures and market disciplineBank failures and market disciplineScope of the paperScope of the paper

Bank fundamentalsBank failuresMarket disciplineBut is there a link between bank failures and market discipline?

Bank failuresBecause of exposure to risks, with no depositor response

Interesting in its own right, but probably a different paperBecause of depositor responses

Fundamental-based vs. panic-based (random)

Market disciplineDepositor responses (not crisis-contingent)Runs that end in failures (crisis-contingent)

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2. Market discipline in banking2. Market discipline in bankingConceptConcept

Market discipline: a situation in which economic agents face costs that increase with bank risk and take actions on the basis of these costs (Berger 1991)

In a principal-agent type of problem, the principal (depositor) by reacting to risk, disciplines the agent (bank manager)

E.g., depositors withdraw their deposits or require higher interest rate when banks take more risk

Reduces ex-ante excessive risk taking in the banking system

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2. Market discipline in banking2. Market discipline in bankingEmpirical testingEmpirical testing

Market discipline has been measured (and generally understood) as the response of market indicators to bank fundamentals (Flannery 1998)

Typically, change in deposits and opposite reaction of interest rates

Not crisis-contingent

In crises with failures, market discipline is used to distinguish random/panic-driven bank runs from fundamental-based runs (e.g. Calomiris and Mason 1997)

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2. Market discipline2. Market disciplineGrowing interestGrowing interest

More interest because of the recent wave of crises

Recent initiatives to enhance market disciplineNew Basel Capital Accord

Minimum capital standards (pillar 1)

Supervisory review process (pillar 2)

Market discipline (pillar 3) as a complement of pillars 1 and 2

BIS (2001) argues market discipline can “promote safety and soundness in banks and financial systems”

Proposals promoting bank issuance of subordinated debt to encourage market discipline (Calomiris 1997, Evanoff and Wall 2001)

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3. Market discipline3. Market disciplineExisting literature – Developed countriesExisting literature – Developed countries

Flannery (1998) reviews the U.S. literature on market discipline by stockholders, bondholders and depositors

Sironi (2003) offers evidence of discipline by subordinated debt holders in the European banking industry

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3. Market discipline3. Market disciplineExisting literature –Existing literature – Developing countriesDeveloping countries

More limited but growing rapidly, with papers appearing in the mid/late 1990s Country cases – whether market discipline exists

Barajas and Steiner (2000) for Colombia, Bundevich and Franken (2003) for Chile, Ghosh and Das (2003) for India, and Schumacher (2000) for Argentina

Deposit insurance and crisesMartinez Peria and Schmukler (2001), Argentina, Chile, and Mexico, Demirgüç-Kunt and Huizinga (2003), cross-country

Subordinated debtCalomiris and Powell (2001), Argentina

Systemic risk, crises, and institutional factorsDe la Torre, Levy Yeyati, and Schmukler (2003), Levy Yeyati, Martinez Peria, and Schmukler (2003)

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4. Contribution of the paper4. Contribution of the paper

Applies the existing methodologies and extends the current evidence on market discipline, using a series of East Asian and Latin American countries

Relates fundamentals to both bank failures, changes in deposits, and interest rates (“market discipline”)

Use of more countries Provides more cross-country evidence about responses to idiosyncratic risk

Still difficult to obtain much more information about the effects of aggregate shocks; power of macro variables

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5. Comments on the paper5. Comments on the paperGeneral commentsGeneral comments

Very interesting and carefully done

Define better value added of paper

Cases of Taiwan and Singapore, why not withdrawals?

Better link bank failures with bank runs Are failures run-induced?

Equal signs in deposit and interest rate equations, which contradicts market discipline

No perfect market discipline because all deposits fell?Still idiosyncratic risks and systemic risk (crisis times)

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5. Comments on the paper5. Comments on the paperGeneral commentsGeneral comments

“Gamble for resurrection”

“Too big to fail”Need to measure bailout or perception of bailout

Unless fully controlling for bank risk

Public banks

Tends to reduce degree of market discipline

Policy prescription: More reliance on market discipline in emerging economies

Less effective than what the paper argues

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5. Comments on the paper5. Comments on the paperSpecific commentsSpecific comments

Paper long but lacking some important details

Why restricting failures to a certain periods

VariablesMacro variables with a lag for endogeneity?

Time dummies instead of macro variables, which are hard to determine

Bank fixed effects plus country fixed effects?

To which sectors bank lend?

Government bonds included in the measure of liquidity

Endogeneity of spreads and interest rates as regressors

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5. Comments on the paper5. Comments on the paperSpecific commentsSpecific comments

PoolingWhy not pooling East Asia and Latin America to gain power?

Regressions per country

To avoid accounting problems across countries

To be able to use more standard CAMEL measures like non-performing loans

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6. Market discipline in emerging economies6. Market discipline in emerging economies

Systemic factorsMore prevalent during crises

Market response versus market discipline

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6. Market discipline in emerging economies6. Market discipline in emerging economiesSystemic factorsSystemic factors

Systemic risk affects market disciplineDirectly, regardless of bank fundamentals (past or future)

Exchange rate risk

Confiscation/default risk

Dual agency instead of agency problems

Indirectly, through expected changes in future fundamentalsE.g., through rapidly deteriorating non-performing ratios

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6. Market discipline in emerging economies6. Market discipline in emerging economiesSystemic factorsSystemic factors

Impulse response functions based on a 10 - Lag VAR. The model is estimated using daily data for 2000 and 2001. Sources: Levy Yeyati, Martinez Peria, and Schmukler (2003)

Response to One Standard Deviation Shock in News

-1.5%

-1.3%

-1.1%

-0.9%

-0.7%

-0.5%-0.3%

-0.1%

0.1%

0.3%

0.5%

1 3 5 7 9 11 13 15 17 19

-1.5%

-1.3%

-1.1%

-0.9%

-0.7%

-0.5%

-0.3%

-0.1%

0.1%

0.3%

0.5%

1 3 5 7 9 11 13 15 17 19

Dollar DepositsPeso Deposits

Days Days

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6. Market discipline in emerging economies6. Market discipline in emerging economiesSystemic factorsSystemic factors

Impulse response functions based on a 10 - Lag VAR. The model is estimated using daily data for 2000 and 2001. Sources: Levy Yeyati, Martinez Peria, and Schmukler (2003)

Response to One Standard Deviation Shock in News

Days Days

-0.8-0.6-0.4-0.20.00.20.40.60.81.01.21.4

1 3 5 7 9 11 13 15 17 19

-0.8-0.6-0.4-0.20.00.20.40.60.81.01.21.4

1 3 5 7 9 11 13 15 17 19

Peso Deposits Dollar Deposits

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6. Market discipline in emerging economies6. Market discipline in emerging economiesSystemic factorsSystemic factors

Cumulative Response of Interest Rates and Deposits to the Five Largest Shocks in Each Series

In the case of interest rates, the figures shown represent percentage point increases, while in the case of deposits, the figures represent percentage changes.Source: Levy Yeyati, Martinez Peria, and Schmukler (2003)

News EMBI NDFCombined Response

Time Deposits - Pesos -20.8% -12.0% -16.5% -49.3%Time Deposits - U.S. Dollars -10.1% -4.3% -5.7% -20.1%Interest Rate on Time Deposits in Pesos 5.1 7.8 17.5 30.4Interest Rate on Time Deposits in U.S. Dollars 2.2 1.0 5.7 8.9

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6. Market discipline in emerging economies6. Market discipline in emerging economiesMarket response versus market disciplineMarket response versus market discipline

Market reactions to risk in general has consequences on the concept and policy implications of market discipline

Finding of lower market sensitivity to bank fundamentals (as the paper shows) does not imply lack of market reaction to risk

In fact, it may be a signal of omitted (systemic) information

As depositors react to systemic shocks and dual agency problems, the principal agency nature of market discipline vanishesOnly when idiosyncratic risk becomes important vis-à-vis systemic risk, market responses can effectively discipline managers

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