Bank Fundamentals, Bank Failures, and Market Discipline by Marco Arena Sergio Schmukler World Bank First Workshop Latin American Finance Network December 11-12, 2003

2 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

3 1.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 1.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)

5 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

6 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)

7 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)

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)

10 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

11 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)

12 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

13 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

14 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

15 6. Market discipline in emerging economies Systemic factors More prevalent during crises Market response versus market discipline

16 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

17 6. Market discipline in emerging economies Systemic factors Impulse response functions based on a 10 - Lag VAR. The model is estimated using daily data for 2000 and Sources: Levy Yeyati, Martinez Peria, and Schmukler (2003) Response to One Standard Deviation Shock in News Dollar DepositsPeso Deposits Days

18 6. Market discipline in emerging economies Systemic factors Impulse response functions based on a 10 - Lag VAR. The model is estimated using daily data for 2000 and Sources: Levy Yeyati, Martinez Peria, and Schmukler (2003) Response to One Standard Deviation Shock in News Days Peso DepositsDollar Deposits

19 6. Market discipline in emerging economies Systemic 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)

20 6. Market discipline in emerging economies Market 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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