Title: Bank Fundamentals, Bank Failures, and Market Discipline by Marco Arena
1Bank Fundamentals, Bank Failures, and Market
Disciplineby Marco Arena
- Sergio Schmukler
- World Bank
- First Workshop
- Latin American Finance Network
- December 11-12, 2003
2Outline
- Bank failures and market discipline
- Market discipline concept and use
- Market discipline existing literature
- Contribution of the paper
- Comments on the paper
- Market discipline in emerging economies
3- 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?
4- 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)
52. 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
62. 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)
72. 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)
8 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
9 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)
104. 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
115. 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)
125. 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
135. 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
145. 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
156. Market discipline in emerging economies
- Systemic factors
- More prevalent during crises
- Market response versus market discipline
166. 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
176. 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)
186. 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)
196. 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)
206. 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
21End