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