Review of Literature and Institutional Background
2.4 The Influence of FSN on Market Discipline
2.4.3 Market Discipline Imposed by Equity holders
2.4.3.2 Determinants of Market Discipline by Equity Holders
One of the main foundation theories that supports the potential power of equity holders as a source of market discipline is the efficient market hypothesis that was first proposed by Fama (1970). This theory suggests that if a capital market is efficient, then in equilibrium, at any time,
10 Using the option-price theory developed by Black and Scholes (1972), Merton (1977) modeled equity as a call option on the assets of banks. This model highlighted the main characteristics of equity holders who have limited liabilities and who are the residual claim holders.
11 The charter value of a bank is broadly defined as the value that would be foregone due to a closure; or the value of a bank being able to continue to do business in the future, reflected as part of its share price (Acharya, 1996).
48 any information published to the market will be reflected in stock prices. That is, the market will react to the information available on the market, such as the publication of financial reports. A survey of literature by Gilbert (1990) and Flannery (1998) concluded that most studies on the price of bank equities confirmed the hypothesis that the price of bank stocks have an inverse relationship to bank risk or a positive relationship to bank fundamentals, ceteris paribus. For example, data on large commercial banks in the US over the period of 1974 to 1983 indicated that the price of bank shares is a function of earnings and capital ratios (Shome, Smith, &
Heggestad, 1986). Correspondingly, by using capital ratio, earning and growth of earning, asset size, and loss rates to estimate the share price of bank stocks, this study found that banks with higher capital ratios and lower loss rates tended to have higher share prices (Beighley, Boyd, &
Jacobs, 1975). Further evidence on the negative association between loan-loss-reserve announcements and returns was found by Docking, Hirschey and Jones (1997) in their study of US bank shares. These studies in general confirm that return on equity is sensitive to financial indicators that are representative of increases in the bank’s riskiness.
External information is also used by equity holders to assess the risk of a bank. For example, the announcement of Moody’s debt-rating downgrades has caused a decline in equity prices since this downgrade represents discrete changes in bank risk. A debt-rating downgrade would increase future uninsured debt-financing costs of banks and, hence, have a negative effect on equity prices (Billett et al., 1998). Shareholders also respond negatively to the announcement of supervisory reviews for remedial actions taken to avoid failure. For instance, in the US market an average of 5% decline in stock prices of banks occurred after the release of this supervisory information (Jordan, Peek, & Rosengren, 2000).
In addition, similar to the previous literature on market discipline exerted by depositors and bond holders, the TBTF perception may also create risk indifference among shareholders of large banks since large banks are expected to have a higher probability of being rescued (Beighley et al., 1975). Interestingly, due to the TBTF perception, evidence from Europe suggests that bank equity prices respond much more reliably to rating agency downgrades than their bond prices (Gropp & Richards, 2001). This late response of bond holders is perhaps caused by a perception that the relevant banks, most of which are large, are TBTF and that bond holders are therefore unconcerned about risk.
Some studies have taken another approach by testing the accuracy of equity returns to assess the soundness of banks. For example, using commonly used equity-based indicators (equity prices, daily returns, volatility, and distance to default) on Italian banks listed on the Milan Stock
49 Exchange between 1995 and 2002, Cannata and Quagliariello (2005) found that equity-based variables reflect equivalent results with the supervisory ratings assigned by the Bank of Italy. in a broader study using the downgrade and upgrade events for 64 European banks for the period of 1995–2002, Distinguin et al. (2006) found that stock prices could be used to predict, with significant accuracy, financial distress for banks. Similarly, in the US market, using data from 11,450 inspections by supervisors from 1996 to 2000, Gunther et al. (2001) found that stock prices can predict the result of supervisory ratings even after taking account of past rating information. Therefore the equity returns provide useful predictive information about a bank’s future performance. These findings in general suggest that the use of market signals for bank monitoring is appropriate and stock market prices might be effective in disciplining banks (Caner et al., 2012).
The potential signaling role of equity prices is important and undervalued, especially in relatively undeveloped markets. An extensive cross-countries analysis by Caprio and Honohan (2004) provided empirical evidence that the likelihood of stock market discipline increases as the assets of listed banks increases as a share of total banking assets in emerging markets.
However, they found no significant evidence for the influencing ability of shareholders on bank management. A more specific study by Caner et al. (2012) on the Turkish financial market found indications of discipline by shareholders, as equity returns have a significant relationship with bank efficiency and liquidity. For shareholders who invest in small banks, the equity returns were also determined by other factors, including trading volume and franchise value; whereas in the case of shareholders of large banks, bank efficiency is not a key concern. The potential of equity prices to signal risk of failure was also found during the East Asian crisis. Bongini, Laeven and Majnoni (2002) highlighted the superior forecasting ability of default probability computed from an equity-price based option price model, not only relative to published ratings but also to a synthetic measure of risk of failure based on accounting data. A more specific study on equity market prices in Thai banks also predicted bank difficulties in the 1997 Asian financial crisis well before rating agencies downgraded their ratings. At that time, the debts of several Thai banks were at junk-bond levels while the rating agencies were still treating them as investment-grade (Saunders & Wilson, 2001).
50 2.4.4 Literature on Market Discipline in the Indonesian Banking Sector
Indonesia provides a unique institutional setting for studying the presence of market discipline in a developing economy and how market discipline is influenced by the provisions of FSN, in particular the deposit insurance program. Indonesia implemented a full deposit guarantee program (blanket guarantee scheme) to restore confidence in the national banking system following the Asian financial crisis in 1997-1998 (Enoch et al., 2001). In order to minimize moral hazard and enhance market discipline, in 2005 the blanket guarantee scheme was replaced by a limited deposit insurance program (Hadad et al., 2011).
The change from a full to a limited guarantee scheme could provide empirical data to evaluate the impact of this change on market discipline. However, literature with respect to market discipline in the Indonesian banking industry is relatively limited. Early studies showed some indication of discipline by the market, for example the “flight to quality” phenomena during the 1997-1998 financial crisis. This phenomenon was demonstrated in the massive withdrawals and re-channeling of deposits from small banks to large banks (Yudistira, 2003) and from domestic private banks to the state owned banks or foreign banks (Enoch et al., 2001; Kameyama et al., 2006). Large banks and state owned banks were considered TBTF as the government would not let the banks shut down for fear of further damaging the banking system (Enoch et al., 2001).
Similarly, the subsidiaries or the branches of foreign banks were expected to be saved by their parent companies in the event of liquidity or solvency crises (Enoch et al., 2001; Kameyama et al., 2006). These depositor actions can be seen as an act of market discipline and, to some extent, the 1997 financial crisis has served as a wake-up call for depositors in relation to their banks (Kameyama et al., 2006).
One of earliest empirical studies that purposely evaluated the existence of discipline by Indonesian depositors was conducted by Valenci (2005). The study used the monthly call report files that were submitted by up to 241 banks to the central bank of Indonesia from January 1980 to December 1999. The study measured the correlation between both the implicit deposit interest rate and the deposit growth rate with the bank fundamentals. The study found no convincing evidence regarding the presence of discipline by the depositors. This finding raises doubts as to whether Indonesian depositors are able to exercise adequate discipline.
More recent empirical studies by Hamada (2011) and Hadad et al. (2011) found that despite the lack of ideal market conditions for an effective market discipline, Indonesian depositors were able to monitor the conduct and the performance of banks. By using panel data from the annual reports of Indonesian banks for the period of 1998 to 2009, Hamada (2011) measured the
51 depositor discipline by the changes in the amount of deposits and interest rates. The study concluded that Indonesian depositors monitor bank soundness and riskiness and select a bank based on the bank’s condition as reflected by the equity ratio. This evidence is an indicator that under the blanket guarantee, depositors prefer to invest their money in well capitalized banks, or request a higher interest rate from risky banks. While under the limited deposit insurance, the depositors shifted their money from the banks that reported an increase in their non-performing ratio, regardless of the interest rate offered by the risky banks.
Using a balanced panel of 104 commercial banks from 1995 until 2009, Hadad et al. (2011) investigated the relationship between implicit deposit interest rates and bank risks. The study found an indication of market discipline as higher deposit rates were associated with higher default risk and with higher liquidity risk. This was particularly evident before the introduction of the deposit guarantee scheme. The results suggested that the regulations concerning the increase of minimum capital requirements and the introduction of a limited deposit insurance scheme provide a credible enhancement of the market monitoring functions. In addition, the evidence illustrates that the depositor discipline is statistically stronger in listed banks than in unlisted banks, and in foreign banks than in domestic banks.
The literature on depositor discipline in the Indonesian banking industry, however, contains four major limitations: the use of unpublished financial reports and unpublished financial ratios; the use of annual reports; and the use of unreliable data during the crisis. First of all, the studies often used the unpublished monthly call report submitted by banks to the regulators (e.g.
Valensi, 2005 & Hadad et al., 2011)12. This method raised the question as to how depositors could respond to the relevant information contained in these financial reports when they were not publicly available.
The financial ratios that were published were those that were calculated by the authors and did not follow the standards followed by Indonesian banks. For example, the Z-score13 was used as a proxy for insolvency risk, and the ratio of liquid assets to total assets was used as a proxy for liquidity risk in Hadad et al. (2011). The calculation and interpretation of those financial ratios would require a certain degree of financial sophistication on the part of recipients (Wu & Bowe, 2012). Therefore, by considering the characteristics of depositors as mostly unsophisticated
12 Data for 1995– 2000 in Hadad et al. (2011) are based on the banks’ condensed published financial statements;
whereas the remaining financial data (2001–2009) are obtained from the banks’ monthly reports to Bank Indonesia.
13 The Z-score is defined as the number of standard deviations that a bank’s return on assets has to fall for the bank to become insolvent (Köhler, 2012).
52 retail investors, it is unrealistic to expect them to spend time and have the capacity to calculate complex financial ratios by themselves and, more importantly, be able to accurately interpret these ratios within the context of their own institutions.
Further, Kameyama et al. (2006) and Hamada (2011) argue that annual reports may not contain sufficient information to adequately capture market dynamics. Empirical evidence indicates the tendency of banks to engage in “window-dressing” adjustment behaviour in bank assets, particularly in the end of financial year reports (Allen & Saunders, 1992). For this reason, in order to gain a deeper insight into the market volatility during the observation period, it is important to employ data with higher frequency.
The studies on market discipline in the Indonesian banking sector are commonly based upon data over the period of pre- and post- the 1997 financial crisis. The structure of the banking industry along with its regulatory environment has been dynamic and therefore comparing banking data before and after the 1997 crisis may impair the validity and reliability of these study results. For instance, in terms of the number of banks, there were 238 commercial banks operating in Indonesia before the crisis in 1997 (Enoch et al., 2001), this number declined to 150 banks in 2000 due to closures, mergers, and acquisitions following the banking sector restructuring program (Batunanggar, 2002). In terms of the reliability of published accounting data, the empirical evidence indicates that during Indonesia’s stable economic periods, the regulators used four of the traditional CAMEL indicators, providing significant insights into their financial soundness. Nevertheless, the relationships between financial soundness and CAMEL ratings substantially deteriorated during the crisis period (Gasbarro et al., 2002).
It is important to note that the present study is unique in several ways. First, the study is based on publicly available financial reports published by banks on a quarterly basis. Use of published financial data is considered more appropriate to measure public responses or sensitivity to bank risk. Second, the sample used in this study covers the period after the 1997 financial crisis to represent a more current regulatory framework and banking structure, and to exclude the unreliable banking data that had been recorded during the crisis period. Third, while the existing market discipline literature commonly measures the behaviour of the Indonesian depositors as a group, this study will further investigate the extent of market discipline (if any) imposed by different types of depositors, in particular the disciplinary actions by retail and large (wholesale) depositors, as well as discipline by insured and uninsured depositors. The current study investigates the extent of discipline by uninsured depositors based on data gathered from the
53 IDIC and is the first to use this data to investigate market discipline in the Indonesian banking industry.
With respect to the proposal for a mandatory subordinated debt to enhance monitoring and disciplinary action by debt holders as mentioned in Section 2.4.2, in emerging countries such as Indonesia, this proposal might not be viable since the market is still relatively small and illiquid compared to the advance economies (Calomiris, 1997; Mishkin, 1996). However, under international banking regulations, deposit taking institutions can already voluntarily issue subordinated debt and include it as part of their regulatory capital for solvency purposes. In the Indonesian case for example, as stipulated in Article 14 of the BI Regulation Number 10/15/PBI/2008 regarding the capital adequacy ratio for Commercial Banks, Indonesian banks can issue subordinated loans or subordinated bonds and use these as the lower tier 2 capital to fulfill the capital adequacy requirement14. The sub-debt can only be calculated at most as 50%
(fifty percent) of tier 1 (core) capital. Interestingly, despite the adoption of the Basel guidelines through the Indonesian banking regulator in utilizing the subordinated bond to enhance market discipline, there has been relatively little or no literature on the ability of debt holders to impose market discipline in the context of the Indonesian market. The results of the study would critically evaluate whether the decision by the Indonesian banking regulator to follow the Basel approach is supported by adequate empirical evidence or not. Secondly, the literature regarding market discipline by private agents in the bond markets for emerging economies is in the early stages of development (Mendonça & Villela Loures, 2009). The present study, therefore, will contribute to the body of knowledge regarding the existence and influence of market discipline in bond markets in developing economies.