1. 14 April 20031 Market discipline and financial stability Glenn Hoggarth Patricia Jackson Erlend Nier

2. 14 April 20032 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

3. 14 April 20033 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

4. 14 April 20034 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

5. 14 April 20035 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

6. 14 April 20036 Main channels for a graduated response Equity price Bank counterparties

7. 14 April 20037 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)

8. 14 April 20038 Cross country panel data set 729 individual banks from 32 countries typically observations from 1993 to 2000

9. 14 April 20039 Identified measures of the strength of market discipline

10. 14 April 200310 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

11. 14 April 200311 Fitch Government support

12. 14 April 200312 Disclosure Constructed an index on core disclosure items from BankScope 18 categories covering following areas -

13. 14 April 200313 US listing NYSE, NASDAC or AMEX

14. 14 April 200314

15. 14 April 200315 Some MKD variables may be endogenous Instrumental variables Two Stage Least Squares procedure

16. 14 April 200316 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

17. 14 April 200317 Implications for public policy

18. 14 April 200318 Limit safety nets/deposit protection schemes Where substantial - more onus on supervisors Encourage greater disclosure - voluntary disclosure seems limited in good times

19. 14 April 200319 Nature of disclosure - comparable disclosure important VaR

20. 14 April 200320

21. 14 April 200321 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

22. 14 April 200322 Basel II will create new common language PD LGD EAD Must meet set standards

23. 14 April 200323 Pillar III Banks resisting comparable disclosure but it is essential – loans by PD band –default outturns –information on LGD

24. 14 April 200324 Use of market prices in supervision Do market prices reflect the riskiness of a bank?

25. 14 April 200325 7 major UK banks Bond spreads Real equity prices Implied volatilities Implied PDs

26. 14 April 200326 Relationship between each market indicator and banks’ accounting ratios

27. 14 April 200327 Panel regressions for the eight UK banking groups - 1995H1 to 2002H2 Test is whether Current properties - Tested leading indicator properties -

28. 14 April 200328 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)

29. 14 April 200329 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

30. 14 April 200330 But market indicators noisy Type II errors quite large 20% large moves could not be explained

31. 14 April 200331 Given importance of counterparties volume/price indicators of exposures might be important