Review of Literature and Institutional Background
2.4 The Influence of FSN on Market Discipline
2.4.1 Market Discipline Imposed by Depositors
2.4.1.2 Market Discipline by Depositors in Developed Countries
In the high-transparency financial environments of developed countries, depositors can discipline banks that engage in excessive risk-taking by requesting higher deposit interest rates or by withdrawing their deposits (Demirguc-Kunt & Kane, 2002). Early literature on market discipline in developed countries mainly focused on the discipline that was enforced by uninsured depositors, such as the holders of large certificates of deposit (CD), large retail and institutional depositors (Hadad et al., 2011; Valensi, 2005). Uninsured depositors have an
5 See Kane (2000, 1995) and Calomiris (1996) for summary of the literature in this subject.
30 incentive to monitor bank activities and to impose additional funding costs on risky banks since their deposits are not fully protected by the government. For example, the earliest studies found limited evidence for the existence of market discipline by evaluating the determinant of the spread of CD interest rate (price effect) in the US market. The statistical evidence shows that some coefficients of risk indicators used by the bank supervisors, such as profitability ratios, loss ratios and capital ratios, are not significant variables in explaining the spread of CD interest rates (Baer & Brewer, 1986; Crane, 1976; Herzig-Marx, Chayim, & Weaver, 1979). In contrast, other studies have found indications of market discipline showing significant results that are consistent with the effectiveness of market discipline theory. For instance, the CD spread variability can be explained significantly by profitability, asset quality, and capital ratios (Hannan & Hanweck, 1988), liquidity ratios (Herzig-Marx et al., 1979), variability of stock prices (Baer & Brewer, 1986; James, 1987), leverage ratios and loss provision ratios (James, 1987).
However, the use of CD as a source of market discipline has received some criticism. First, in terms of the amount, as the individual stakes of CD holders are relatively small compared to other sources of funds such as bonds and shares. Consequently, the power of CD holders as a source of market discipline is considerably weak (De Ceuster & Masschelein, 2003). Second, the disciplining power of CDs is limited because the short-term tenor of CDs and the availability of a liquid secondary market. This makes the CD holders able to sell certificates quickly before they mature, such as in the United Kingdom (UK) market (Hamalainen et al., 2003). Third, despite some statistical evidence regarding the strong correlation between bank risk and large deposit interest rates, the ability of a supervisor to extract information is limited because most CD interest rate data are not publicly available (Flannery, 2001). Furthermore, banks whose debts are downgraded by a rating agency quickly shift their funds by raising the use of insured deposits (Billett, Garfinkel, & O'Neal, 1998). This finding shows that the discipline exercised by CD holders, through an increase in the required return or withdrawal of uninsured deposits, may produce limited effects. This is because the proportion of CD is relatively small and banks are able to shift the uninsured CD funds to the insured deposits (Jordan, 2000).
To sum up, research concerning disciplinary actions by depositors in developed countries tends to employ uninsured large deposits, such as CD, as a proxy to measure market discipline. A large number of studies have found evidence that supports the hypothesis regarding sensitivity of the CD interest rates against bank fundamentals. However, the use of CD interest rates for a regulatory measure should not be overstated due to the limitations of CDs in disciplining banks.
31 2.4.1.3 Market Discipline by Depositors in Developing Economies
In developing economies, data on CD is limited because its use is not popular and its number is insignificant compared to the whole third party funds in the banking sector (Hadad et al., 2011).
Therefore, unlike in developed countries, studies on discipline by depositors in emerging economies commonly use ordinary deposit such as saving, demand, and time deposits (Valensi, 2005).
As discussed earlier, financial markets in developing economies notably differ from their counterparts in developed economies. This is mainly due to the lack of ideal preconditions for an effective market mechanism, such as, for example, the absence of sufficient and relevant market information and infrastructures. The level of transparency plays an essential role since banks that disclose more information will be subject to more market discipline and have a greater incentive to limit their risk of default (Baumann & Nier, 2003; Calomiris, 1997; Levy-Yeyati et al., 2004a). In the context of developing economies, financial information generation is very costly, corporate governance is weak, and banks are more likely to ignore market discipline (Ward, 2002). Therefore, due to the lack of information and the low level of bank transparency, the presence and the effectiveness of market discipline in developing economies is in doubt (Calomiris, 1997; Caprio & Honohan, 2004; Mishkin, 1996; Ward, 2002).
Despite limited necessary conditions for an effective market discipline, a significant number of studies have found empirical evidence that confirmed the existence of market discipline imposed by depositors in developing economies. For instance, depositors discipline banks for taking riskier activities by withdrawing their funds, as found in Colombia (Barajas & Steiner, 2000), China (Wu & Bowe, 2012), and Russia (Karas, Pyle, & Schoors, 2010). Depositors punished risky banks by demanding higher interest rate in Poland (Mondschean & Opiela, 1999) and Indonesia (Hadad et al., 2011). Moreover, depositors punished banks for risky behaviour, both by withdrawing their deposits and by requiring higher interest rates as found in Argentina, Chile, and Mexico (Calomiris & Powell, 2001; Martinez-Peria & Schmukler, 2001), in India (Ghosh &
Das, 2003), and Bolivia (Luzio-Antezana, 2001). In short, these empirical results support the hypothesis that maintains that market monitoring of banks can exist and complement public monitoring by bank regulators, even in less sophisticated financial markets (Hadad et al., 2011;
Martinez-Peria & Schmukler, 2001; Mondschean & Opiela, 1999).
However, Levy-Yeyati et al. (2004b) could not find evidence that Argentinean and Uruguayan depositors disciplined their banks during the crisis period of 2000-2001. The weak evidence regarding the existence of market discipline in developing economies can be attributed to several
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.