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Market Discipline in Commercial Banking: Evidence from the Market for Bank Equity

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  • Ayesha Afzal

    ()
    (Lahore School of Economics, Pakistan.)

  • Nawazish Mirza

    ()
    (Lahore School of Economics, Pakistan)

Abstract

This study presents empirical evidence of market discipline, using a panel dataset of listed banks on the Karachi Stock Exchange. We construct multiple riskbased measures from the stock prices between 2004 and 2009 to determine whether an increase in the risk profile results in an increase in compensation for depositors and other creditors. The risk variables used include market risk, value at risk, size and value premium, default likelihood indicator, price relatives, and a control variable representing gross domestic product growth. We find a significant relationship between our risk factors and cost of deposits, indicating that banks align deposit compensation with their risk perception. However, we cannot find a link between the market perception of risk and deposit switching. These findings have important implications for policymakers as market discipline could complement the state’s regulatory role and lower the cost of supervision. Our estimations of value at risk and the default likelihood indicator using stochastic simulations is a methodological contribution that could be used for effective risk management practices.

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Bibliographic Info

Article provided by Department of Economics, The Lahore School of Economics in its journal Lahore Journal of Economics.

Volume (Year): 16 (2011)
Issue (Month): Special Edition (September)
Pages: 233-254

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Handle: RePEc:lje:journl:v:16:y:2011:i:sp:p:233-254

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Keywords: Market Discipline; Karachi Stock Exchange; Value at Risk; Default Likelihood Indicator.;

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  1. Bongini, Paola & Laeven, Luc & Majnoni, Giovanni, 2002. "How good is the market at assessing bank fragility? A horse race between different indicators," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 1011-1028, May.
  2. Shimizu, Katsutoshi, 2009. "Is the information produced in the stock market useful for depositors?," Finance Research Letters, Elsevier, vol. 6(1), pages 34-39, March.
  3. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
  4. Reint Gropp & Jukka Vesala & Giuseppe Vulpes, 2002. "Equity and bond market signals as leading indicators of bank fragility," Conference Series ; [Proceedings], Federal Reserve Bank of Boston.
  5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  6. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  7. Breen, William J & Lerner, Eugene M, 1973. "Corporate Financial Strategies and Market Measures of Risk and Return," Journal of Finance, American Finance Association, vol. 28(2), pages 339-51, May.
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