Argentina Currency Crisis (PowerPoint) by MikeJenny

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									Bank Fundamentals, Bank Failures,
      and Market Discipline
          by Marco Arena

          Sergio Schmukler
             World Bank

             First Workshop
     Latin American Finance Network
          December 11-12, 2003
Outline

1. Bank failures and market discipline
2. Market discipline: concept and use
3. Market discipline: existing literature
4. Contribution of the paper
5. Comments on the paper
6. Market discipline in emerging economies



                                             2
1. Bank failures and market discipline
Scope of the paper
 Question 1:
 To what extent can we explain cross-country differences
 in crisis outcomes by appealing to ex-ante cross-country
 differences in micro level bank fundamentals?
 Question 2:
 Do depositors in crisis countries discipline riskier banks
 by withdrawing their deposits and/or by requiring higher
 interest rates in such a way that deposit withdrawals
 could be considered an act of market discipline?

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1. Bank failures and market discipline
Scope of the paper
 Bank fundamentals
    Bank failures
    Market discipline
    But is there a link between bank failures and market discipline?

 Bank failures
    Because of exposure to risks, with no depositor response
       Interesting in its own right, but probably a different paper
    Because of depositor responses
       Fundamental-based vs. panic-based (random)

 Market discipline
    Depositor responses (not crisis-contingent)
    Runs that end in failures (crisis-contingent)
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2. Market discipline in banking
Concept
 Market discipline: a situation in which economic agents
 face costs that increase with bank risk and take actions
 on the basis of these costs (Berger 1991)
   In a principal-agent type of problem, the principal (depositor)
   by reacting to risk, disciplines the agent (bank manager)
   E.g., depositors withdraw their deposits or require higher
   interest rate when banks take more risk
   Reduces ex-ante excessive risk taking in the banking system




                                                                     5
2. Market discipline in banking
Empirical testing
 Market discipline has been measured (and generally
 understood) as the response of market indicators to bank
 fundamentals (Flannery 1998)
   Typically, change in deposits and opposite reaction of interest
   rates
   Not crisis-contingent

 In crises with failures, market discipline is used to
 distinguish random/panic-driven bank runs from
 fundamental-based runs (e.g. Calomiris and Mason
 1997)

                                                                     6
2. Market discipline
Growing interest
 More interest because of the recent wave of crises
 Recent initiatives to enhance market discipline
   New Basel Capital Accord
      Minimum capital standards (pillar 1)
      Supervisory review process (pillar 2)
      Market discipline (pillar 3) as a complement of pillars 1 and 2
          BIS (2001) argues market discipline can “promote safety and
          soundness in banks and financial systems”
   Proposals promoting bank issuance of subordinated debt to
   encourage market discipline (Calomiris 1997, Evanoff and
   Wall 2001)

                                                                        7
3. Market discipline
Existing literature – Developed countries
    Flannery (1998) reviews the U.S. literature on market
    discipline by stockholders, bondholders and
    depositors

    Sironi (2003) offers evidence of discipline by
    subordinated debt holders in the European banking
    industry




                                                            8
3. Market discipline
Existing literature – Developing countries
    More limited but growing rapidly, with papers appearing in the
    mid/late 1990s
    Country cases – whether market discipline exists
       Barajas and Steiner (2000) for Colombia, Bundevich and Franken
       (2003) for Chile, Ghosh and Das (2003) for India, and Schumacher
       (2000) for Argentina
    Deposit insurance and crises
       Martinez Peria and Schmukler (2001), Argentina, Chile, and Mexico,
       Demirgüç-Kunt and Huizinga (2003), cross-country
    Subordinated debt
       Calomiris and Powell (2001), Argentina
    Systemic risk, crises, and institutional factors
       De la Torre, Levy Yeyati, and Schmukler (2003), Levy Yeyati,
       Martinez Peria, and Schmukler (2003)
                                                                            9
4. Contribution of the paper

  Applies the existing methodologies and extends the
  current evidence on market discipline, using a series of
  East Asian and Latin American countries
  Relates fundamentals to both bank failures, changes in
  deposits, and interest rates (“market discipline”)
  Use of more countries
     Provides more cross-country evidence about responses to
     idiosyncratic risk
         Still difficult to obtain much more information about the effects of
         aggregate shocks; power of macro variables


                                                                                10
5. Comments on the paper
General comments
  Very interesting and carefully done
  Define better value added of paper
  Cases of Taiwan and Singapore, why not withdrawals?
  Better link bank failures with bank runs
       Are failures run-induced?

  Equal signs in deposit and interest rate equations, which
  contradicts market discipline
  No perfect market discipline because all deposits fell?
       Still idiosyncratic risks and systemic risk (crisis times)
                                                                    11
5. Comments on the paper
General comments
  “Gamble for resurrection”
  “Too big to fail”
       Need to measure bailout or perception of bailout
           Unless fully controlling for bank risk
       Public banks
       Tends to reduce degree of market discipline

  Policy prescription: More reliance on market discipline
  in emerging economies
       Less effective than what the paper argues

                                                            12
5. Comments on the paper
Specific comments
  Paper long but lacking some important details
  Why restricting failures to a certain periods
  Variables
       Macro variables with a lag for endogeneity?
       Time dummies instead of macro variables, which are hard
       to determine
       Bank fixed effects plus country fixed effects?
       To which sectors bank lend?
       Government bonds included in the measure of liquidity
       Endogeneity of spreads and interest rates as regressors
                                                                 13
5. Comments on the paper
Specific comments
  Pooling
      Why not pooling East Asia and Latin America to gain
      power?
      Regressions per country
            To avoid accounting problems across countries
            To be able to use more standard CAMEL measures
            like non-performing loans




                                                             14
6. Market discipline in emerging economies

  Systemic factors
       More prevalent during crises

  Market response versus market discipline




                                             15
6. Market discipline in emerging economies
Systemic factors
 Systemic risk affects market discipline
   Directly, regardless of bank fundamentals (past or future)
      Exchange rate risk
      Confiscation/default risk
          Dual agency instead of agency problems
   Indirectly, through expected changes in future fundamentals
      E.g., through rapidly deteriorating non-performing ratios




                                                                  16
 6. Market discipline in emerging economies
 Systemic factors
                 Response to One Standard Deviation Shock in News

                     Peso Deposits                                              Dollar Deposits
0.5%                                                       0.5%
0.3%                                                       0.3%
0.1%                                                       0.1%
-0.1%                                                      -0.1%
-0.3%                                                      -0.3%
-0.5%                                                      -0.5%
-0.7%                                                      -0.7%
-0.9%                                                      -0.9%
-1.1%                                                      -1.1%
-1.3%                                                      -1.3%
-1.5%                                                      -1.5%
        1   3    5    7   9      11   13   15   17   19            1   3    5    7    9     11   13   15   17   19
                          Days                                                       Days




 Impulse response functions based on a 10 - Lag VAR. The model is estimated using daily data for 2000 and 2001.
 Sources: Levy Yeyati, Martinez Peria, and Schmukler (2003)                                                     17
6. Market discipline in emerging economies
Systemic factors
                Response to One Standard Deviation Shock in News

                   Peso Deposits                                              Dollar Deposits

 1.4                                                       1.4
 1.2                                                       1.2
 1.0                                                       1.0
 0.8                                                       0.8
 0.6                                                       0.6
 0.4                                                       0.4
 0.2                                                       0.2
 0.0                                                       0.0
-0.2                                                      -0.2
-0.4                                                      -0.4
-0.6                                                      -0.6
-0.8                                                      -0.8
       1   3   5    7    9      11   13   15   17   19           1   3   5    7    9    11   13   15   17   19
                         Days                                                       Days




Impulse response functions based on a 10 - Lag VAR. The model is estimated using daily data for 2000 and 2001.
Sources: Levy Yeyati, Martinez Peria, and Schmukler (2003)                                                     18
6. Market discipline in emerging economies
Systemic factors
        Cumulative Response of Interest Rates and Deposits to the Five
                       Largest Shocks in Each Series


                                                                                                         Combined
                                                               News           EMBI            NDF        Response
 Time Deposits - Pesos                                           -20.8%         -12.0%         -16.5%        -49.3%
 Time Deposits - U.S. Dollars                                    -10.1%          -4.3%          -5.7%        -20.1%
 Interest Rate on Time Deposits in Pesos                             5.1            7.8           17.5          30.4
 Interest Rate on Time Deposits in U.S. Dollars                      2.2            1.0            5.7           8.9




In the case of interest rates, the figures shown represent percentage point increases, while in the case of deposits, the
figures represent percentage changes.
Source: Levy Yeyati, Martinez Peria, and Schmukler (2003)
                                                                                                                       19
6. Market discipline in emerging economies
Market response versus market discipline
 Market reactions to risk in general has consequences on the
 concept and policy implications of market discipline
    Finding of lower market sensitivity to bank fundamentals (as
    the paper shows) does not imply lack of market reaction to risk
       In fact, it may be a signal of omitted (systemic) information
    As depositors react to systemic shocks and dual agency
    problems, the principal agency nature of market discipline
    vanishes
    Only when idiosyncratic risk becomes important vis-à-vis
    systemic risk, market responses can effectively discipline
    managers


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