Bank Fundamentals, Bank Failures, and Market Discipline by Marco Arena

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Bank Fundamentals, Bank Failures, and Market
Disciplineby Marco Arena

• Sergio Schmukler
• World Bank
• First Workshop
• Latin American Finance Network
• December 11-12, 2003

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Outline

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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• Bank failures and market discipline
• Scope 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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• Bank failures and market discipline
• Scope of the paper

• Bank fundamentals
• Bank failures
• Market discipline
• But is there a link between bank failures and
  market discipline?
• Bank failures
• Because of exposure to risks, with no depositor
  response
• Interesting in its own right, but probably a
  different paper
• Because of depositor responses
• Fundamental-based vs. panic-based (random)
• Market discipline
• Depositor responses (not crisis-contingent)
• Runs that end in failures (crisis-contingent)

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2. Market discipline in banking Concept

• 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 banking Empirical 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 discipline Growing interest

• More interest because of the recent wave of
  crises
• Recent initiatives to enhance market discipline
• New 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 discipline Existing 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 discipline Existing literature
Developing 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 crises
• Martinez Peria and Schmukler (2001), Argentina,
  Chile, and Mexico, Demirgüç-Kunt and Huizinga
  (2003), cross-country
• Subordinated debt
• Calomiris and Powell (2001), Argentina
• Systemic risk, crises, and institutional factors
• De la Torre, Levy Yeyati, and Schmukler (2003),
  Levy Yeyati, Martinez Peria, and Schmukler (2003)

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4. 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 paper General 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 paper General 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 paper Specific comments

• Paper long but lacking some important details
• Why restricting failures to a certain periods
• Variables
• Macro 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 paper Specific comments

• Pooling
• Why 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 economies

• Systemic factors
• More prevalent during crises
• Market response versus market discipline

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6. Market discipline in emerging
economies Systemic factors

• Systemic risk affects market discipline
• Directly, 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
  fundamentals
• E.g., through rapidly deteriorating
  non-performing ratios

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6. Market discipline in emerging
economies Systemic factors
Response to One Standard Deviation Shock in News
Dollar Deposits
Peso Deposits
Days
Days
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)
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6. Market discipline in emerging
economies Systemic factors
Response to One Standard Deviation Shock in News
Peso Deposits
Dollar Deposits
Days
Days
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)
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6. Market discipline in emerging
economiesSystemic 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)
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6. Market discipline in emerging economiesMarket
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 vanishes
• Only when idiosyncratic risk becomes important
  vis-à-vis systemic risk, market responses can
  effectively discipline managers

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End