Download - 14 April 20031 Market discipline and financial stability Glenn Hoggarth Patricia Jackson Erlend Nier
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14 April 2003 1
Market discipline and financial stability
Glenn HoggarthPatricia JacksonErlend Nier
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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
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Channels for market disciplineEquity price - cost and availability of
capital- takeover target
Affected by• shareholders limited liability - gambling for resurrection• expectations of support• sub-contract monitoring to regulators
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Bank counterparties• cost and availability of funding• access to swap and derivative
contacts• graduated reaction more likely from
wholesale counterpartiesAffected by• deposit protection arrangements• too big to fail
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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
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Main channels for a graduated response
• Equity price• Bank counterparties
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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)
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Cross country panel data set
• 729 individual banks from 32 countries• typically observations from 1993 to
2000
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Identified measures of the strength of market discipline
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Depositor protectionIndex on existence and extentDepins 2 = 1 or 0 - if schemes existDepins 3 = 1 or 0 - no co-insuranceDepins 4 = 1 or 0 - interbank deposits coveredDepins 5 = 1 or 0 - unlimited coverage
Depins = sum of depins 2, depins 3, depins 4, depins 5
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Fitch
Safety net 1 if public support rating = 1 or 2
0 = 3, 4, 5
Government support
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Disclosure
Bank’s risk profile - interest rate risk- credit risk- liquidity risk- market risk
Capital and reserves
Constructed an index on core disclosure items from BankScope
18 categories covering following areas -
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US listing
NYSE, NASDAC or AMEX
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ititititit ZMKDRISKfCAP ),,(
Risk - components of weekly equity returns- one period ahead loan loss provisions
Z - control variables - return on equity- log of total assets- GDP growth
MKD - market disclosure/market disciplinevariables
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Some MKD variables may be endogenous
Instrumental variables Two Stage Least Squares procedure
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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
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Implications for public policy
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• Limit safety nets/deposit protection schemes
• Where substantial - more onus on supervisors
• Encourage greater disclosure - voluntary disclosure seems limited in good times
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Nature of disclosure
Lloyds HSBC AbbeyStandardChartered Barclays
95%,1 day
99%,10 days
95%,1 day
97.5%,> 1 day
98%,1 day
- comparable disclosure important
VaR
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Basel I - risk asset ratio- set weightings for assets- set definition for capital
Probably most widely assessedstatisticBut many banks do not discloseTier 1 ratio
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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
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Basel II will create new common language
• PD• LGD• EAD
Must meet set standards
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Pillar III
• Banks resisting comparable disclosure but it is essential– loans by PD band–default outturns– information on LGD
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Use of market prices in supervision
Do market prices reflect the riskiness of a bank?
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7 major UK banks
Bond spreads
Real equity prices
Implied volatilities
Implied PDs
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Relationship between each market indicator and banks’ accounting ratiosMarket Indicators Balance sheets
measures of riskBond spread(over risk-free rate)
Excess capital ratioabove the regulator’sminimum
Real equity price Provisions/total assets
Implied probabilitiesof default
Risk-weightedassets/total assets
Implied volatilities
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Panel regressions for the eight UK banking groups - 1995H1 to 2002H2
2it21it1
2it21it1it
IndicatorMarketIndicatorMarketIndicatorRiskIndicatorRiskIndicatorRisk
Test is whether 021 ββ
Current properties -
it10it IndicatorRiskIndicatorMarket
Tested leading indicator properties -
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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)
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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
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But market indicators noisy
• Type II errors quite large• 20% large moves could not be
explained
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Given importance of counterparties
• volume/price indicators of exposures might be important