Bank stability, transparency and the safety net Erlend Nier Bank of England 15 September 2006

Introduction Large number of banking crises throughout 1990s in countries as diverse as Japan, Turkey, Argentina, SE Asian countries. However, little agreement as regards the structural causes of instability. What is the role of –Lack of transparency –Safety nets –Inadequate supervision and regulation?

Introduction Suspicion among policymakers that ‘recent crises owe some of their intensity to a general lack of transparency’ and that ‘practices and policies responsible for the depth of recent crises would not have been undertaken, had they been required to be made public’ (Fischer, 1999, p. 563)

Introduction Policy response: strengthen market discipline through more disclosure Stated aim of Basel 2, Pillar 3 disclosures is to provide ex ante incentives for banks to more prudently manage their risks.  Important to know whether these measures are likely to have a beneficial effect on stability.

Existing cross-country research (eg Barth, Caprio and Levine (2004)) has not been able to document an impact of bank transparency on incidence of crises. –small sample problem – countries –banking crisis hard to define –judgement (eg Caprio and Klingebiel, 2003) –large number of factors (eg macro, etc) –marginal impact of structural factors may be small. –transparency hard to measure

This study offers new approach by investigating banking problems at the individual bank level. –Large cross-country sample of > 500 banks from 32 countries, from –Define crisis at the bank level, using a market indicator of crisis dramatic fall in stock price –Measure transparency at the bank level >3000 observations on transparency

Bank transparency appears to reduce the incidence of banking problems. These effects are stronger for countries in which financial and institutional development is weak. Safety nets: effect of deposit insurance depends on design (explicit versus unlimited protection) Explicit (in contrast to implicit) schemes appear to reduce the incidence of problems Unlimited schemes appear to increase incidence of problems Supervision and regulation: appear to have little effect on incidence of banking problems Main Take-away

Detail - Overview 1. Conceptual Background 2. Existing empirical research 3. Research design market indicator of crises measuring transparency 4. Main result and extensions 5. Conclusion

Conceptual Background Ex ante: transparency can create market discipline and reduce moral hazard eg Boot and Schmeits (2000) Ex post: –Tansparency can destabilise (ex post) when banks suffer from recoverable weakness, eg Cordella and Yeyati (1998) –Transparency can stabilise (ex post) since it reduces scope for informational contagion, eg Gorton and Huang (2002)

Existing Empirical Research Transparency –has no discernable effect on the likelihood of crises, Barth, Caprio and Levine (2004) Deposit insurance –Explicit insurance increases likelihood of crises, Demirguc-Kunt and Detragiache (2002) decreases likelihood of crises, Eichengreen and Arteta (2000), Gropp and Vesala (2004) –More generous protection (unlimited coverage) increases likelihood of crises, Demirguc-Kunt and Detragiache (2002) Regulation and Supervision: –Barth, Caprio and Levine (2004), Beck, Demirguc-Kunt and Levine (2005) do not find strong evidence for an effect on banking crises

Research Design Use sample of > 500 listed banks from 32 different countries from 1994 – 2000 Define market indicator of crisis at bank level Define c(i, t) =1 if bank i experiences a crisis in year t –if stock return falls into 5 per cent tail of unconditional distribution –Cut-off equivalent to return of -50% p.a.

Frequency of crisis, c(i,t)=1

Research Design - Probit Perform probit regressions M: Macroeconomic controls B: Bank-specific controls S: Structural variables

Structural factors (S) Transparency disclosure index records for 17 items of possible disclosure whether or not bank provides information in its annual accounts as represented in BankScope database –is normalised to range between zero and 1 –direct measure of the quantity of information provided

Disclosure sub-indices

Structural factors (S) Deposit insurance explicit=1 if an explicit deposit insurance scheme exists unlimited=1 if an explicit scheme exists and if it provides unlimited coverage –Source: Demirguc-Kunt and Sobaci (2000) Financial Development Stock market capitalization, credit to GDP Supervision and regulation Various measures of capital, supervisory power, restrictions on activities, entry, obtained from Barth et al (2004)

Macroeconomic controls (M) current account (-) interest rate (+) GDP growth (+) Bankspecific controls (B) risk (beta) (+) profitability (-) size (-) NB: All variables enter with a one-year lag

Main Results on Transparency (1) Probit (2) Probit Dep. Variablec(i, t) L1Disc ** *** Year0.1710***0.0902*** Logsize ** *** L1Beta0.2717*0.3442*** L1Roa ** *** L1Current * L1Interest L1Gdp_g5.1397* Constant *** *** No. of obs No. of banks

Main Results on Transparency Disclosure appears to reduce incidence of banking problems All control variables have the expected sign and are significant in most regressions. –Crises preceded by high Gdp growth –Crises preceded by high deficits –Crises preceded by high nominal rates –Larger banks less crisis prone –High correlation (beta) banks more crisis prone –Profitable banks less crisis prone

Transparency and Safety Nets (1) Probit(2) Probit Dep. Var.c(i, t) L1Disc *** *** Explicit *** *** Unlimited0.3306*** Controls…..…. Constant *** *** No. of obs No. of banks537562

Transparency and Safety Nets Explicit deposit insurance significantly reduces the likelihood of crises, in line with Eichengreen and Arteta (2000), Gropp and Vesala (2004). Unlimited insurance significantly increases the likelihood of crises, in line with Demirguc-Kunt and Detragiache (2002) Effect of Transparency robust to inclusion of features of safety net.

Transparency and Financial Development (1) Probit(2) Probit Dep. Variablec(i, t) L1Disc Explicit Unlimited Controls Stmcap Pcredit L1Discstmcap L1Discpcredit Constant *** *** ** … ** * *** *** *** ** … ** ** *** No. of obs. No. of banks

Transparency and Financial Development Financial development appears to reduce incidence of banking problems Effect of transparency robust to inclusion of measures of financial development Transparency has a stronger effect in countries in emerging economies, where financial development is still weak (independent of measurement), in line with Giannetti (2006)

Transparency and Regulation (1) (1) Probit(2) Probit(3) Probit Dep. Variablec(i, t) C(I, t) L1Disc Explicit Unlimited Controls L1Cap Capstring Suppower Constant *** *** *** … *** *** *** *** … *** *** *** *** ** … *** No. of obs. No. of banks

Transparency and Regulation (2) (4) Probit(5) Probit(6) Probit Dep. Variablec(i, t) L1Disc *** *** *** Explicit *** *** *** Unlimited0.2985**0.4023***0.3284** Controls…..…. Activ Entry * Bankconc Constant *** *** *** No. of obs No. of banks

Transparency and Regulation Results generally in line with Beck et al (2005) and Barth et al (2004). –Capital stringency reduces banking problems, in line with Barth et al (2004) –Entry restrictions associated with increase in incidence of problems, in line with Beck et al (2005), and Schaeck et al (2006) However, overall evidence is weak. Effects of both transparency and safety net robust to inclusion of these variables.

Conclusion More transparency may significantly reduce the likelihood of banking crises, Ex ante disciplining effect Reduction of contagion –Effect is stronger for emerging markets, in line with theory (Giannetti, 2006) confirming anecdotal evidence on genesis of crises during1990s. Evidence lends support to initiatives to increase transparency by mandating more disclosure, eg through Pillar 3 of Basel 2

Conclusion Safety nets also important: –Explicit deposit insurance decrease the likelihood of crises Consistent with Eichengreen and Arteta (2000) and Gropp and Vesala (2004) –Generous depositor protection may increase the likelihood of crises. Cosnsistent with Demirguc-Kunt and Detragiache (2002) Other structural variables related to supervision and regulation appear to have little effect in our sample, in line with Beck et al (2005) and Barth et al (2004).