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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
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14 April 2003 1
Market discipline and financial stability
Glenn HoggarthPatricia JacksonErlend Nier
14 April 2003 2
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 2003 3
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
14 April 2003 4
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
14 April 2003 5
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 2003 6
Main channels for a graduated response
• Equity price• Bank counterparties
14 April 2003 7
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 2003 8
Cross country panel data set
• 729 individual banks from 32 countries• typically observations from 1993 to
2000
14 April 2003 9
Identified measures of the strength of market discipline
14 April 2003 10
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
14 April 2003 11
Fitch
Safety net 1 if public support rating = 1 or 2
0 = 3, 4, 5
Government support
14 April 2003 12
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 -
14 April 2003 13
US listing
NYSE, NASDAC or AMEX
14 April 2003 14
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
14 April 2003 15
Some MKD variables may be endogenous
Instrumental variables Two Stage Least Squares procedure
14 April 2003 16
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 2003 17
Implications for public policy
14 April 2003 18
• Limit safety nets/deposit protection schemes
• Where substantial - more onus on supervisors
• Encourage greater disclosure - voluntary disclosure seems limited in good times
14 April 2003 19
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
14 April 2003 20
Basel I - risk asset ratio- set weightings for assets- set definition for capital
Probably most widely assessedstatisticBut many banks do not discloseTier 1 ratio
14 April 2003 21
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 2003 22
Basel II will create new common language
• PD• LGD• EAD
Must meet set standards
14 April 2003 23
Pillar III
• Banks resisting comparable disclosure but it is essential– loans by PD band–default outturns– information on LGD
14 April 2003 24
Use of market prices in supervision
Do market prices reflect the riskiness of a bank?
14 April 2003 25
7 major UK banks
Bond spreads
Real equity prices
Implied volatilities
Implied PDs
14 April 2003 26
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
14 April 2003 27
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 -
14 April 2003 28
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 2003 29
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 2003 30
But market indicators noisy
• Type II errors quite large• 20% large moves could not be
explained
14 April 2003 31
Given importance of counterparties
• volume/price indicators of exposures might be important
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