The Topic of Market Discipline in Banking Finance Essay

Improve market discipline in banking is one of the three pillars proposed by the Basel Committee on Banking Supervision in January 2001. This new Basel Capital Accord contains new rules to respond to the deficiencies of the previous accord on credit risk which was made in 1988. First pillar is calculating risk weights for different kinds of loans by using different rating methods for counterparts like standard method, Foundation Internal rating Based (FIRB), Advanced Internal Rating Based (AIRB). Second pillar introduces the principle of a structured dialogue between banking institutions and supervisors. Third pillar is focused on transparency and market discipline. Transparency rules are established for the information made available to the public on assets, risks and their management. In this essay we focus on market discipline to describe how it can be a way to reduce banks' risk-taking, why supervisors wanted to introduce this notion in rules of supervision and finally what are the difficulties of enhancing market discipline in banking. First of all we are going to define this concept, what it means and its role in banking and then we discuss factors affecting market discipline and how to enhance it and finally conclude with a brief relief with the recent financial crisis.

The concept of market discipline :

Market discipline means the responsibility on the banks and financial institutionsA toA conduct business while considering the risks to their stakeholders. Market discipline promotes the transparency and disclosure ofA the risks associated withA a business. This concept was inserted in the third pillar for improve the safety and soundness of the market. More precisely in banking, it means that banks are more control by the market than they were before, because their stakeholders control their activities and especially on risks of these activities, if they think that business of their bank is too risky, they will demand a higher premium. This phenomenon is the same with bank's depositors, if they think there is a big risk of their bank to fail, they will require a higher rate on their deposits or they simply leave this bank to go on other less risky. Thus, in order to not pay a higher premium on liabilities and to convince depositors and other counterparts of their financial strength, banks will be encouraged to reduce risks. To enhance the role of market discipline in financial markets, the third pillar requires the bank activities to be transparent to the general public. For this, the bank is supposed to release relevant financial data (financial statements etc) in a timely fashion to the public, for example, through its webpage. This might enable depositors to better evaluate bank condition (the probability for the bank to fail) and diversify their portfolio in accordance.

Factors affecting market discipline :

The first factor affecting market discipline in banking is the formal deposit insurance which has been established in most developed countries around the world (first introduced in the USA in 1933 after the great depression). Formal deposit insurance is a credible way to prevent bank runs which are very negative for countries' economy (it would be too long to explain all negative factors of bank runs in this essay) as we have seen in the 1929 crisis for example. In this case, banks pay a premium to a private or public insurer who repays depositors in case the bank fails. But now the problem is that deposit insurance generates moral hazard problems and the decrease or disappearance of market discipline. The reason why deposit insurance can encourage banks to take excessive risk is, if depositors are sure to be repaid in case of failure they have no more incentives to monitor their bank, while deposits are insured, bank's behavior on risks is not their concern. Without deposit insurance depositors will be concerned about the riskiness of bank's assets and will require a higher rate whenever the bank increases its risk of failure. Therefore with deposit insurance market discipline imposed by depositors is not effective anymore. And even when insurance is capped, market discipline lost its role because the cap is too High. Second factor is the status "too big to fail" of some big banks. "Too Big to Fail" is a phrase referring to the idea that in economic regulation, the largest and most interconnected businesses are so large that a government cannot allow them to declare bankruptcy because failure would have a disastrous effect on the overall economy. As a matter of fact this phrase is true for numerous institutions and their stakeholders. But how this principle can affect market discipline ? Gradually, lenders to big banks understood that their money was no longer at risk. And the banks realized that the bigger and more complicated they got, the safer they would be from market discipline and so they became. Lenders to the commercial banks had known that the government implicitly protected them, and thus didn't worry much about what the banks were doing with their money, including extending to much risky activities. Thus we understand that for lenders, claims are implicitly protect by the countries' government, so they don't have any incentives to manage banks' risk-taking. This principle is also applicable for stockholders and for the management of banks: As stockholders realized their investment was somewhat protected by governments, they had no incentives to control banks but had incentives that it takes more risk to benefit from any increase in pay related to their shares. Actually benefit from higher leverage of their stocks. And finally, the greater the risk is, the higher the profits are, the greater the shareholders grant compensation to bankers. So, with this principle, bankers and stockholders have strong incentives to increase banks' risk-taking, market discipline is totally inefficient.

The base of market discipline: publishing information.

The Basel Committee aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. Supervisors have the authority to require banks to provide information in regulatory reports. Some supervisors could make some or all of the information in these reports publicly available. Furthermore, banks' management may choose to provide the Pillar 3 information through other means such as on a publicly accessible internet website or in public reports. Information should be generally published on a semi-annual basis, but few exceptions exist. For example the obligation for large international banks and other significant banks to have to disclose their Tier 1 and total capital adequacy ratios, and their components, on a quarterly basis. The new Basel capital accord has defined 13 tables specifying precisely the qualitative and quantitative disclosures to publish to enhance market discipline such as capital adequacy, credit risk, banking book positions on equities.

A way to enhance market discipline: The subordinated debt

Subordinated debt is a debt that is either unsecured or has a lower priority than that of another debt claim on the same asset or property. It can be also called junior debt. Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy, below the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors. Because subordinated debt is repayable after other debts have been paid, they are more risky for the lender and typically have a higher rate of return than senior debt due to the increased inherent risk. This type of debt is uninsured. Argument for subordinated debt is that because of its junior status, its yield should be more sensitive to changes in risk than are the yields of large denomination deposits. In the event of bank failure, subordinated debt holders will be the last in line for recovery of their claims. If all large banks were required to issue the same type of subordinated debt, market participants and regulators would be able to compare yields associated on these debts and would have an easy means of comparing banks' default risk. Then regulators could impose to the banks with the highest yield corrective actions or more rigorous examination, the yield spread which result can also be used to determine a deposit insurance premium for the bank. Thus, impose a certain level of subordinated debt in banks' liabilities can be a way to improve market discipline. However, it still exists some problems or interrogations about this role of subordinated debt in enhancing market discipline. One problem is that investors can be more concerned about the liquidity of those securities than in other on the same bank because as subordinated debt has a longer maturity than others, banks which has a narrow secondary market for it or do not trade at all will find that yields incorporate a relatively larger illiquidity premium. Thus yields will be not very representative of the default risk and not easy to compare between banks. Other reason is as Gorton and Santomero have noted, if the risk for subordinated debt-holders to lose all the value of their investment is high, their incentives can be the same as stockholders when the probability of bankruptcy is high. In this case, pay-off distribution of these two different types of investors is the same, and there are incentives to increase risk and reduce control. Last reason is to identify the correct model of the determination of subordinated debts yields. The implicit model in many studies is that investors price the securities according to the perceived level of risk of the banks. But we can also think that investors can price assets regarding the risk that regulators will close the bank. Logically, investors will be less encouraged to monitor a bank considered "too big to fail". In conclusion, we can say that market discipline is an important topic in discussions of regulatory authorities who have also registered as Pillar 3 of the new Basel Agreement. Indeed we have seen that it could be a way to force banks to limit risk in their activities. However it may be affected by several factors like deposit insurance, which is very important too in order to limit bank rushes. A solution might be to impose on banks a certain level of subordinated debt in order to really encourage those creditors to monitor and supervise risks taken by banks. Nevertheless, it also has drawbacks. This will require in the future finding solutions to improve market discipline because we have seen in the recent crisis an inherently riskier banking system because of insufficient incentives and mechanisms to control excessive risk-taking, and a stronger wish on supervisors to protect the banking system, Furthermore, the strong growth of financial innovations, including products more and more sophisticated, in the sense where the risk associated with assets is difficult to collect, and certain shortcomings in the rating agency have made it difficult to control banks. Thus with the financial globalization, it is increasingly difficult to supervisors to control banks' risks, so in the future, the market discipline will probably become more and more important as a complement of banking supervision's rules

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