Review of Literature and Institutional Background
2.4 The Influence of FSN on Market Discipline
2.4.1 Market Discipline Imposed by Depositors
2.4.1.4 Determinant of Market Discipline Imposed by Depositors
32 factors. These include the level of transparency, the extent of government deposit insurance, government ownership of banks, and macroeconomic variables (Levy-Yeyati et al., 2004b). The impact of market and macroeconomic variables on market discipline is discussed further in Section 2.4.1.4.
33 to generate more funds at lower prices poses a potentially undesirable problem. These banks, are more likely to receive larger subsidies through an implicit TBTF policy thereby reinforcing managerial risk-taking incentives and increasing banking system fragility, particularly in a concentrated financial market (Mishkin, 2000).
The ownership structure of a bank, such as public ownership via capital markets and foreign ownership, is considered a non-fundamental variable that could play an important role in depositor behaviour. The empirical evidence suggests that from a depositor perspective, listed banks are generally more favourably viewed because of two main aspects: first, banks that disclose more information are subject to stronger market discipline that could limit their risk- taking behaviour (Hadad et al., 2011) and reduce the probability of default by choosing a higher capital buffer (Nier & Baumann, 2006); and second, depositors may be more confident in placing their deposits in listed banks due to the inherent diversity of their ownership structures.
This means that control is not limited to one party but share across the ownership group (Wu &
Bowe, 2012). These external pressures both from markets and equity holders are considered important in order to improve the corporate governance of banks (Nier & Baumann, 2006). For these reasons, listed banks are often able to attract more deposits than other banks.
In developing economies, foreign ownership in the form of bank subsidiaries or branches is perceived as having advantages over domestic counterparts. This advantage might be derived from the strong reputation of parent companies (Barajas & Steiner, 2000) and a more solid capital structure than the average domestic bank. This, in turn, would prevent the subsidiaries or branches of foreign banks from liquidation (Kameyama, Satiadhi, Alijoyo, & Bouma, 2006). As a result, these banks are expected to perform better than the average domestic bank if they wish to attract more deposits.
Moreover, as discussed in Section 2.4.1.3, the strength of market discipline is influenced not only by the idiosyncrasies of a bank, but also market environment conditions, particularly in developing economies where systemic risk exerts a significant impact on the behaviour of depositors. This impact would probably overshadow the role of bank fundamentals in driving market responses (Levy-Yeyati et al., 2004b). Therefore, a study of market discipline in developing economies needs to take into account systemic risks. This includes the provision of a deposit guarantee program, government ownership of banks (partly caused by government recapitalization and nationalization programs), and macroeconomic variables (Cubillas, Fonseca,
& González, 2012; Levy-Yeyati et al., 2004a).
34 The strength of depositor discipline is potentially affected by moral hazard behaviour associated with a deposit insurance scheme. A government guarantee, both explicit and implicit, may limit the responsiveness of the yield or return on bank liabilities to changes in the bank risk of default and thus limit the incentive effects of market discipline (Baumann & Nier, 2003). In this case, depositors might not monitor bank financial performance indicators such as the published CAMEL ratios because there are no sufficient incentives for depositors (especially insured depositors) to monitor capital and loss exposures of banks. As a consequence, a deposit insurance system shifts responsibility for monitoring bank risk-taking from depositors to regulators (Demirguc-Kunt & Kane, 2002). Therefore, when market conditions are not well developed or in the presence of a deposit insurance, it is often argued that market discipline could not exist (Caprio & Honohan, 2004).
The literature comprises a considerable number of publications on the moral hazard implications of a deposit insurance program on market discipline. A study by Demirgüç-Kunt and Huizinga (2003) comprehensively examines the disciplinary role of interest rates and deposit growth in a bank-level dataset covering 43 countries over the period 1990-1997. The finding confirms that explicit deposit insurance lowers bank interest expenses and makes depositors less sensitive to bank risks. Cubillas et al. (2012), using a panel data set of banks from 66 countries that experienced a combined 79 banking crises over the period 1989-2007, conclude that on average market discipline weakens after a banking crisis. They also note that the weakening of market discipline is positively related to the accommodative policies applied to contain and resolve the crisis, such as the adoption of an explicit blanket guarantee, regulation forbearance, government recapitalization, and nationalization programs. A study in Turkey found that deposit guarantee schemes reduced market discipline during the period 1988-2000 (Onder & Ozyildirim, 2003). In Poland, after the new law concerning the deposit insurance program for private banks went into effect, the bank specific variables became less important in explaining differences in deposit interest rates (Mondschean & Opiela, 1999). In general, these studies present evidence that both explicit and implicit deposit guarantees might reduce incentives for depositors to exercise market discipline.
It is interesting to note that even though a deposit guarantee might lessen the disciplining power of the market, it would not eliminate it completely. Many studies suggest that market discipline will continue to be present to a certain extent under a deposit insurance program. In the US markets for example, the seminal study by Flannery (1998) supports the view that even in the presence of the federal guarantees, large CD rates sensibly react to the changes in bank risks.
35 Moreover, this study also found that retail depositors have been shown to behave rationally by withdrawing their money when some banks exhibit solvency problems. In the Japanese market, even after the reinstatement of deposit insurance, depositors were still able to discipline riskier banks by withdrawing their funds from troubled financial institutions (Fueda & Konishi, 2007).
The presence of market discipline under a deposit guarantee program might be attributed to the notion of weaknesses in the credibility of the guarantees, gaps in coverage, delays and other costs entailed in recovering funds from the guarantor (Demirguc-Kunt & Kane, 2002).
Market discipline may survive under a deposit insurance program if depositors perceive that the deposit insurance scheme is not credible (Martinez-Peria & Schmukler, 2001). The lack of credibility of a deposit insurance program can be attributed to at least two main reasons: first, a government promise to secure public money in banks might not be credible since the governments had reneged on their policies to handle troubled banks and guarantee programs in the past (C. A. E. Goodhart, 2008; Martinez-Peria & Schmukler, 2001); second, the credibility of a deposit insurance system also depends on its funding structure (Martinez-Peria & Schmukler, 2001). An inadequate funding structure can lead to a loss of credibility in the deposit insurance system (Financial Stability Forum, 2001). Empirical evidence suggests that market discipline intensifies when the ability of deposit insurance to cover its guarantees is ineffective (Demirguc- Kunt & Kane, 2002; Martinez-Peria & Schmukler, 2001). The loss of credibility due to inadequate funding sources is particularly common in developing economies (C. A. E. Goodhart, 2008; Mishkin, 1996)6.
As recommended by the Financial Stability Forum (2001), market discipline can be fostered under deposit insurance programs by implementing a co-insurance or a partial deposit insurance scheme. Partial deposit insurance could encourage market discipline imposed by sophisticated depositors, particularly uninsured depositors (Bhattacharya, Boot, & Thakor, 1998). Uninsured depositors, who potentially lose their assets if the bank is liquidated, are expected to monitor and discipline their banks by demanding a higher return or withdrawing their funds (Flannery, 2001).
Empirical evidence in the US markets validate this correlation since interest rates paid on partially insured instruments increase significantly with bank riskiness (Baer & Brewer, 1986;
Brewer & Mondschean, 1994; Demirguc-Kunt & Kane, 2002; Flannery, 1998; Hannan &
Hanweck, 1988). Similar patterns were also found in Argentina, Chile and Mexico where
6 The Financial Stability Forum (2001) recommends that a deposit insurance system should have adequate and accessible funding mechanisms to ensure the prompt reimbursement of depositor claims after a bank failure.
36 uninsured depositors acted as effective monitors of bank risk (Martinez-Peria & Schmukler, 2001).