Research Framework and Empirical Models
3.3 Conceptual Framework
The development of an effective market discipline mechanism, as discussed in Chapter 2, requires four main ingredients: available and reliable information, market participant capability to utilize information, mechanisms to adjust securities relative to bank risk level, and financial institution responses to market signals. These requirements are the four interrelated building blocks that form a market discipline framework (Stephanou, 2010), as shown in Figure 3.1.
Building block 1 represents the need for sufficient and reliable information (Caprio & Honohan, 2004; Crockett, 2002; Llewellyn, 2005) provided by an open capital market and public disclosure regulations of bank capital structure and risk exposure (Lane, 1993). The information and disclosure about the financial performance and risk exposures of a bank should be adequate, timely, consistent, reliable, and available to the general public (Hamalainen et al., 2003).
Building block 2 emphasizes the need for a sufficient number of independent market participants with the ability to accurately process the available information (Crockett, 2002), as well as the interest and adequate incentives to monitor a bank (Crockett, 2002; Llewellyn, 2005), including no bail out policy anticipated by market participants (Lane, 1993). Building block 3 illustrates the need for an effective mechanism and various instruments for market players to exercise discipline by adjusting risks to the price and quantity of investment portfolios (Caprio &
Honohan, 2004; Crockett, 2002; Llewellyn, 2005)
83 Figure 3.1 Market Discipline Framework
Adapted from Stephanou (2010)
Building block 4 relates to the ability of the governance structure within the organization to adequately respond to market signals, to control bank risks, and to adjust management behaviour in response to market signals based on appropriate incentives for bank management (Lane, 1993;
Llewellyn, 2005). Figure 3.1 indicates that, in general, market discipline consists of two distinct components: ‘monitoring’ (recognize) and ‘influence’ (control) phases (Bliss & Flannery, 2002).
Therefore, Flannery and Sorescu (1996) suggest that an effective market discipline must satisfy a two-stage process, in which market players can ‘recognize’ and ‘control’ the risk of financial institutions. The mechanism for how this market discipline works is illustrated in Figure 3.2.
The monitoring (or recognition) phase in Figure 3.2 refers to the hypothesis that market players can adequately evaluate changes in a financial institution condition and incorporate those assessments promptly into their portfolios. Therefore, in this phase, market participants should be aware of risk and be able to effectively monitor bank risk (Bliss & Flannery, 2002). Market players need to be aware and consider themselves at risk of loss if the bank defaults, giving them an incentive to react to perceived changes in the likelihood of bank insolvency (Lane, 1993; Nier
& Baumann, 2006; Van Hoose, 2010). Secondly, market discipline requires independent market players to effectively observe bank risk (Flannery, 2001). For an effective observation, market
84 players must have adequate information to measure the riskiness of the bank, and the financial market should be efficient for investors to exercise discipline in a manner that provides appropriate market signals (Caprio & Honohan, 2004; Crockett, 2002; Lane, 1993; Van Hoose, 2010). In addition, successful market discipline also requires investors to process information correctly (Crockett, 2002). An absence of correct information may result in inaccurate signals being transmitted to bank management and supervisors. Market monitoring mechanisms generate market signals, from primary or secondary markets, that may convey useful information to bank management and supervisors (Hamalainen et al., 2003).
However, the incentive for market participants to continuously monitor their banks might be impeded by the provision of a FSN, such as the provision of a deposit insurance scheme or financial rescue mechanisms (Crockett, 2002; Flannery, 2001). The provision of a FSN could reduce the default risk of a bank and hence may create moral hazard problems originating from bank management and from market players (Hamalainen et al., 2003).
The influence (or control) phase in Figure 3.2 refers to a process by which outside parties influence the action of a financial institution (Hamalainen et al., 2003). Market responses to changes in the bank's risk profile (from the monitoring phase) need to have cost implications for the bank and its managers (Nier & Baumann, 2006), so that bank management has an incentive to adjust their behaviour (Lane, 1993; Llewellyn, 2005). Bank management reacts to the information derived from market-monitoring activities (direct market discipline) generally by lowering their risk profile. In addition, the signals from the market can be utilized by supervisors to impose supervisory corrective actions on the part of banks (indirect market discipline) (Flannery, 2001; Hamalainen et al., 2003).
85 Figure 3.2 Market Discipline Mechanism
Source: Adapted from Hamalainen et al. (2005)
The present study is designed to evaluate the presence of market discipline, specifically in the monitoring phase as illustrated in Figure 3.2. In relation to Figure 3.1, the effectiveness of the monitoring phase depends on three elements (building blocks) in the market discipline framework. These are: the availability of information and disclosure (Block 1), the existence of an adequate number of market participants (Block 2), and the presence of various instruments to exercise discipline mechanisms (Block 3)29. Furthermore, the conceptual framework of this study is developed upon these three elements of the monitoring phase. The detail of the proposed conceptual framework is illustrated in Figure 3.3. The framework is divided into three main elements: bank information and disclosure; market participants; and discipline mechanisms.
These three elements emphasize the presence of market discipline which is indicated by the
29 The influencing phase and the last block (internal governance) are beyond the coverage of this study. However, the findings provide policy implications for management to improve their internal governance, as well as to banking sector authorities in order to enhance the overall market discipline.
86 capability of independent market participants to make reasonable assessments based on available information, particularly accounting information that represents bank fundamentals.
Bank fundamentals in this study refer to bank financial performance that is commonly used by financial authorities to assess bank soundness. These financial ratios can vary from one study to another but most of them replicate CAMEL ratios. In the Indonesian context, the qualitative rating of various aspects affecting the condition or performance of a bank is associated with the BI Regulation Number 6/10/PBI/2004 concerning Rating System for Commercial Banks. The quarterly financial report comprises not only a financial position report (balance sheets) and profit and loss report, but also bank financial ratios that represent CAMEL indicators. In this report, the capital indicator is represented by the Capital Adequacy Ratio (CAR); rating of the asset quality factor is measured by Non-Performing Loan (NPL); rating of the management factor is measured by an Operating Expenses to Operating Revenue ratio (OPEX); rating of the earnings indicator is measured by Return on Assets (ROA) and Net Interest Margin (NIM); and rating of the liquidity factor is represented by the condition of Loan to Deposit Ratio (LDR).
87
Figure 3.3 Conceptual Framework of Market Discipline Imposed by Depositor, Bond Holder, and Equity Holder
88 As argued in Chapter 2, the most appropriate approach to study the behaviour of market players is by using the information that is available to the public. Therefore, this study intentionally employs only financial information that is publicly available, such as published financial reports, securities rating from rating agencies, and trading data from capital markets.
In the Indonesian case, according the BI regulation30, banks are obliged to prepare and present to the BI periodic financial reports, such as annual reports, quarterly financial reports, monthly financial reports, and certain specific reports as required by BI. In addition, the BI regulations specifically state that a bank is required to periodically announce the quarterly published financial report in at least one Indonesian daily newspaper, which has wide circulation at the domicile of bank’s head office or the domicile of the foreign bank branch office31. Based on this requirement, in order to measure market reaction towards the publication of financial reports, this study will use the quarterly published financial reports since they are widely available to the public, not only on bank websites, but also as distributed though national newspapers.
In accordance with prior studies and the literature reviewed in Chapters 2, three key market participants with an interest in enforcing market discipline have been identified and incorporated into the research framework. As illustrated in Figure 3.3, the presence of market discipline in this study is signaled by three classes of market participants: depositors, debt holders, and equity holders. The third building block is the disciplinary mechanism through which market players are able to adjust the price or volume of bank securities to reflect their risk preferences. In this study, discipline by depositors is measured using deposit growth rates, whereas discipline by shareholders and bond holders are assessed through equity returns and bond yields, respectively.
The study framework includes other control variables for systemic market risk and bank ownership and size factors that may influence the investment decision of market players. The systemic market risk, in particular, relates to the provision of government FSN. As argued in Chapter 2 and illustrated in Figure 3.3, the safety net might create moral hazard problems by encouraging risk-taking activities by bank management and stakeholders. Furthermore, the ownership structure of a bank, such as state ownership, foreign investor ownership, and public
30BI Regulation Number 14/14/PBI/2012 Concerning Bank Report Transparency and Publication and BI Regulation Number 13/19/PBI/2011 Concerning the Amendment to Bank Indonesia Regulation Number 8/12/PBI/2006 Concerning the Periodic Report of Commercial Bank.
31The announcement of the quarterly financial report should be made no later than the 15th of the second month after the end of the reporting month for report positions at the end of March, June, and September, and the 15th of April of the following year for report positions at the end of December.
89 ownership via capital market, might affect the behaviour of stakeholders toward bank risk.
Lastly, the presence of the TBTF perception amongst market participants is investigated, particularly in relation to rescue mechanisms as part of the government FSN.