Research Data and Results of the Bond Holder Model
5.3 Analysis and Discussions of the Results
5.3.3 Discussion
The following sections present an interpretation of the regression results, with particular reference to the hypotheses outlined in Chapter 3. Four hypotheses were presented in relation to the association of debt risk premiums with bank fundamentals, types of bond, ownership structure, and the size of bank.
5.3.3.1 The Association of Bond Yield with Bank Fundamentals
The objective of the first hypothesis was to estimate the existence of market discipline by measuring the impact of bank fundamentals on bond yield spreads. Theoretically, if the market price of uninsured bank liabilities, such as bonds, reflects the risk of default, then the market can
166 be seen as playing an effective role in disciplining the banks. As explained earlier, the usual approach taken to verify whether market prices of uninsured bonds contain individual bank risk premiums is to regress the yield spread against an accounting measurement of bank risk.
Preliminary evidence gathered from the present study suggests the presence of market discipline as most of the individual bank risk variables had a statistically significant effect on yield spreads.
To a large extent, these results validate the hypothesis that unsophisticated markets are still able to provide market disciplines (Calomiris & Powell, 2001; Levy-Yeyati et al., 2004a).
The main bank fundamental measures employed in this study were the CAMEL ratios, comprising capital adequacy, asset quality, management capability, earning, and liquidity that were published quarterly by the Indonesian banks. The first measure of risk preference used in the estimation was CAR. Consistent with previous studies, this indicator had a negative impact on debt spreads (Balasubramnian & Cyree, 2011; Levy-Yeyati et al., 2004a; Mendonça &
Villela Loures, 2009; Menz, 2010). These results imply that in the Indonesian bond market, higher levels of solvency among banks will generally lower credit risk and, in turn, lowering the risk premium.
The asset quality in this model was measured by credit risk as represented by the changes in NPL. An increase in the impairment level of loan ratios would increase credit risk which, in turn, would increase the risk premium demanded by investors (Balasubramnian & Cyree, 2011; Menz, 2010). As mentioned earlier, banks with a higher degree of risk aversion prefer borrowers with a good credit record. Consequently, high risk borrowers, in general, are able to meet their fund requirements mostly from banks with aggressive approaches to lending and are willing to take higher levels of risk. Hence, a change in the level of impaired loans (NPL) is an indicator of the current preferences for risk-taking activities by banks. The evidence presented in Section 5.3.1 that Indonesian investors punished banks with an increase in the NPL ratio with higher bond yields is a clear indication of the presence of market discipline.
Management capability was measured by efficiency levels as indicated by the ratio of OPEX, through which banks that are unable to manage their costs effectively are considered to be risky (Martinez-Peria & Schmukler, 2001). The empirical evidence suggests that less efficient banks had a higher interest rate spread, which was an indication of the presence of market discipline.
Consequently, if a less efficient bank issues new bonds in the Indonesian bond market, the bank would face comparatively higher interest expenses than its peers.
167 The earnings capability in this study was represent by the NIM and ROA. The NIM was the difference between interest earned and interest paid by the banks, which reflects the ability of the banks to generate operating income that can be utilized to repay its current and future obligations. This includes the payment of principal and the periodical interest payments on financial instruments. The regression results present evidence of a negative association between NIM and risk premium. This finding confirms the presence of market discipline because bond holders were capable of rewarding banks with a higher profitability ratio with lower required rate of return (Avery et al., 1988; Jagtiani et al., 2002).
The ROA ratio was employed to measure the efficiency of the banks in using resources to generate income. Previous studies have found an inverse relationship between ROA and the probability of bond defaults (Avery et al., 1988; Jagtiani et al., 2002). The present study found a statistically significant correlation between yield spread and ROA. However, contrary to the expectation, this study found a positive sign in the relationship between ROA and interest rate yields in the Indonesian bond market. A possible explanation for this result is related to the concern of the Indonesian bond holders about the risk-taking activities of banks. A high ROA ratio, especially over the crisis period, can be seen as an indication of aggressive attempts by banks to earn short-term profit at the expense of long-term commitment to bank sustainability.
As argued by Flannery (2001) and Bliss (2001), debt holders do not benefit from the upside movement of returns that may be associated with increased risk-taking. Hence, if the market assesses that a higher ROA is possible only with higher risk-taking, the ROA coefficient should have a positive sign (Balasubramnian & Cyree, 2011). This means that the Indonesian bond holders are not in favour of the high risk activities of banks. However, to implicitly answer the question whether these results are influenced by the risk perception of investors or not is beyond the scope of this study.
The DER, which can be regarded as a proxy for liquidity risk, had a positive association with the risk premium in the study sample. This result confirms previous empirical evidence that a higher level of leverage implies a higher risk of default, and thus a higher interest rate yield (Mendonça
& Villela Loures, 2009; Sironi, 2003).
The liquidity risk was measured by the size of bonds issued by banks, and as Menz (2010) argues, bonds with a sizeable par value are typically issued by large banks and are more liquid in the secondary market. Therefore, the risks of large bonds are lower compared to those associated with smaller ones. However, in contrast to Menz’s findings, the results of this study suggest that in the Indonesian bond market, the relationship between the size of bond and the yield was
168 positive, which leads to the conclusion that bonds with higher face values seem to offer higher yields in order to attract buyers. One possible explanation for this relationship between bond size and yield spread was the illiquid market conditions that perhaps removed the different levels of liquidity risk between large and small bonds in the Indonesian market. This lack of noticeable difference in the liquidity levels induces the bond holders to pay greater attention to interest rates.
Consistent with the exiting literature (Avery et al., 1988; Balasubramnian & Cyree, 2011;
Flannery & Sorescu, 1996; Jagtiani et al., 2002; Mendonça & Villela Loures, 2009; Morgan &
Stiroh, 2001; 2003), the present study found an inverse relationship between bond rating and the required returns. The size of the coefficient, however, was quite small, implying a weak impact.
This situation, according to Avery et al. (1988), might be caused by the deficiencies in the market infrastructure that can potentially limit the ability of market participants to exercise discipline. Another possible reason for this observation is the FSN itself which distorts the signals on financial viability of banks (Flannery and Sorescu, 1996; Imai, 2007).
5.3.3.2 The Association of Bond Yield with Type of Bond
The second hypothesis was to test whether the market discipline imposed depends on the type of bond - subordinated or senior. As argued by Menz (2010), due to the strong dependence of financial institutions on the bond market, as long as the risks are adequately priced, senior bonds have the potential to be used as a tool to exert market discipline. However, most literature supports the hypothesis that subordinated bonds have a greater risk of losing their value in the event of bank closures, making it necessary to offer relatively higher returns on subordinated bonds (Caldwell, 2005; Hamalainen et al., 2010). Therefore, it is of particular importance to understand the behaviour of debt holders with respect to the seniority of bonds.
The hypothesis was tested by including a dichotomous variable to represent subordinated debts.
The results, however, failed to indicate any significant difference between these two types of bonds. Further, in terms of interaction between sub-debt and individual CAMEL variables, only the debt leverage ratio was found to have any significant correlation. As discussed in Section 5.3.1 , this particular observation could be due to the anomaly over the period of crisis when the yield spreads between the government and corporate bonds were negative. These abnormal spreads were observed mainly because the yields of government bonds were higher than corporate bonds. To obtain a more reliable result, a further investigation was undertaken by
169 excluding the negative yield spreads that occurred in the crisis period. This modified investigation produced evidence for significant differences in terms of the yield spreads between the subordinated bonds and the senior bonds, confirming the findings of Menz (2010). These results indicate that, with the exception of the period of global financial crisis, there is evidence to support the presence of market discipline exerted by debt holders through demanding higher returns on subordinated bonds.
5.3.3.3 The Association of Bond Yield with Ownership Structure
The current literature posits that government ownership of banks has the potential to limit the extent of market discipline, especially in emerging economies where state owned enterprises still play a dominant role. In order to examine this premise in the context of Indonesia, a dichotomous variable of STA_BANK was included in the equation. As described in Section 5.3.1 , the results of the full sample indicate a significant correlation but the sign is contrary to the expectation as suggested in the literature (Levy-Yeyati et al., 2004a). Considering the abnormal yield spreads during the 2008 global financial crisis, a further investigation concerning the relationship between yield spreads and government ownership was conducted by excluding the negative spreads in the regression (a similar procedure as was taken in Section 5.3.3.2 ). The results of this regression indicate that, in general, state banks paid lower risk premiums than Indonesian private banks. This result verifies the argument by Sironi (2003), who maintains that private agents do not impose market discipline on state owned banks on the understanding that the government would not let its banks fail. In terms of the interaction between the individual CAMEL indicators and the STA_BANK variable, only the ROA showed a significant correlation. To conclude, the regression results indicate that market discipline imposed on the basis of ownership structure is weak.
5.3.3.4 The Association of Bond Yield with Size of Bank
The last of the hypotheses tested was with respect to the doctrine of TBTF. The regression results indicate that bank total assets, as a proxy for bank size, had a statistically significant inverse relationship with bond yields. The results imply that the bond interest rates issued by large banks were considerably lower than that of small banks. According to Sironi (2003) and Deyoung et al. (1998), this result can be interpreted as an indication of the presence of market discipline by bond holders.
170 Bond holders are willing to accept a lower interest rate from the larger banks for a range of reasons. For instance, large banks are considered less risky because the major banks generally have better governance and higher levels of working capital compared to their smaller counterparts. In relation to the safety net, a lower interest rate was accepted because of the lower default risk under the doctrine of TBTF (Levy-Yeyati et al., 2004a). As described in Chapter 3, under the existing Indonesian FSN framework, a bank that poses a systemic risk to the industry would be rescued by the government in the event of bankruptcy.
5.3.3.5 The Association of Bond Yield with Macroeconomic Variables
Three macroeconomic indicators were included in the model as control variables, the most notable being GDP as an indicator of economic activity. As mentioned in Chapter 3, the present study did not expect a particular sign on the relationship between yield spread and macroeconomic indicators. The regression results show an inverse relationship between bond interest rates and GDP, which is an indication that during high economic growth, market participants were willing to lower their required rate of return. In contrast, as the risk of default increases during times of financial crises, the market would demand a higher yield to compensate for the increasing risks.
In line with the above finding, the movement of the Indonesian central bank’s benchmark interest rates shows similar patterns. In the Indonesian market, the yield spread, in general, widens when the central bank reduces its benchmark rate, usually with the objective of improving economic growth, and the opposite policy is adopted to slowdown an overheating economy.
Lastly, the volatility of the domestic currency exchange rate against the US dollar demonstrates a positive relationship. This indicates that the spread between corporate and government bonds widens when the exchange rate depreciates substantially, usually as an impact of economic turbulence in the domestic market. On the other hand, when the economic conditions and the exchange rates return to normal, the risk premiums decline accordingly.