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Bank Fundamentals, Bank Bank Fundamentals, Bank Failures, and Market DisciplineFailures, and Market Discipline
by Marco Arenaby Marco Arena
Sergio Schmukler
World Bank
First Workshop
Latin American Finance Network
December 11-12, 2003
2
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
3
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?
4
1.1. Bank failures and market disciplineBank failures and market disciplineScope of the paperScope of the paper
Bank fundamentalsBank failures
Market discipline
But 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 paper
Because of depositor responses
Fundamental-based vs. panic-based (random)
Market disciplineDepositor responses (not crisis-contingent)
Runs that end in failures (crisis-contingent)
5
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
6
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)
7
2. Market discipline2. Market disciplineGrowing interestGrowing 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 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 existsBarajas 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
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 paper5. Comments on the paperSpecific commentsSpecific 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 economies6. 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 economies6. Market discipline in emerging economiesSystemic factorsSystemic 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
17
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
-0.4-0.20.0
0.20.40.60.8
1.01.21.4
1 3 5 7 9 11 13 15 17 19
-0.8-0.6
-0.4-0.2
0.00.20.4
0.60.8
1.01.21.4
1 3 5 7 9 11 13 15 17 19
Peso Deposits Dollar Deposits
19
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 30.4
Interest 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 vanishes
Only when idiosyncratic risk becomes important vis-à-vis systemic risk, market responses can effectively discipline managers
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EndEnd