14 April Market discipline and financial stability Glenn Hoggarth Patricia Jackson Erlend Nier

14 April Effective market discipline Market must have information to assess riskiness Market participants must be at risk of loss The cost to a bank of an adverse market view must be significant

14 April Channels for market discipline Equity price- cost and availability of capital - takeover target Affected by shareholders limited liability - gambling for resurrection expectations of support sub-contract monitoring to regulators

14 April Bank counterparties cost and availability of funding access to swap and derivative contacts graduated reaction more likely from wholesale counterparties Affected by deposit protection arrangements too big to fail

14 April Subordinated debt but does give the banks added flexibility re capital Affected by expectations of support Accounts for around 3% of total liabilities of UK banks

14 April Main channels for a graduated response Equity price Bank counterparties

14 April What is the effect of transparency? Does it make market discipline more effective? Bank of England research tested the effect of disclosure “Market Discipline, Disclosure and Moral Hazard in Banking” (Nier and Baumann)

14 April Cross country panel data set 729 individual banks from 32 countries typically observations from 1993 to 2000

14 April Identified measures of the strength of market discipline

14 April Depositor protection Index on existence and extent Depins 2 = 1 or 0 - if schemes exist Depins 3 = 1 or 0 - no co-insurance Depins 4 = 1 or 0 - interbank deposits covered Depins 5 = 1 or 0 - unlimited coverage Depins = sum of depins 2, depins 3, depins 4, depins 5

14 April Fitch Government support

14 April Disclosure Constructed an index on core disclosure items from BankScope 18 categories covering following areas -

14 April US listing NYSE, NASDAC or AMEX

14 April

14 April Some MKD variables may be endogenous Instrumental variables Two Stage Least Squares procedure

14 April Deposit insurance and support have a negative effect on capital US listing and disclosure index have a positive effect on capital Results Tested if existence or not of a rating was significant - it was not

14 April Implications for public policy

14 April Limit safety nets/deposit protection schemes Where substantial - more onus on supervisors Encourage greater disclosure - voluntary disclosure seems limited in good times

14 April Nature of disclosure - comparable disclosure important VaR

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14 April Over time risk asset ratio became less comparable - by March 1998 non-mortgage securitisation 10 largest US bank holding companies $200 billion - equivalent to 25% of risk- weighted loans

14 April Basel II will create new common language PD LGD EAD Must meet set standards

14 April Pillar III Banks resisting comparable disclosure but it is essential – loans by PD band –default outturns –information on LGD

14 April Use of market prices in supervision Do market prices reflect the riskiness of a bank?

14 April major UK banks Bond spreads Real equity prices Implied volatilities Implied PDs

14 April Relationship between each market indicator and banks’ accounting ratios

14 April Panel regressions for the eight UK banking groups H1 to 2002H2 Test is whether Current properties - Tested leading indicator properties -

14 April All market measures reflected one or more of the current balance sheet measures of risk but no evidence of leading indicator properties (over and above information from lagged balance sheet measures)

14 April Event study Week of 16 known adverse events 4 market indicators moved right direction - 75%-83% of the time Implied volatilities best reflectors of risk

14 April But market indicators noisy Type II errors quite large 20% large moves could not be explained

14 April Given importance of counterparties volume/price indicators of exposures might be important