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Divergence of risk indicators and the conditions for market discipline in banking

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  • Jens Forssbaeck
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    Abstract

    Accurate measurement of bank risk is a matter of considerable importance for bank regulation and supervision. Current practices in most countries emphasize reliance on financial statement data for assessing banks’ risk. However, the possibility of increased reliance on market-based risk indicators has been a topic for academic and regulatory debate for a long time. Market monitoring of bank risk has typically been tested by regressing market-based risk indicators on various benchmark indicators (such as accounting ratios and credit ratings) to detect whether the market tracks bank risk. This approach overlooks the methodological ‘unobservability’ problem that testing one imperfect proxy indicator against another, when the true value (in this case, a bank’s ‘true’ risk) is unknown, must yield limited conclusions as to the appropriateness of either indicator – particularly in the event of failure to establish a significant association. This paper assesses the relative information content of different risk indicators indirectly by associating the divergence between these indicators with the institutional setting. Empirical results for a large panel of banks worldwide suggest that market-based indicators are often more accurate than accounting indicators for high levels of institutional quality. In particular, spreads on subordinated debt may be more informative than either equity-based or accounting-based measures if the institutional conditions for market discipline to function are favourable. In addition, a combination measure incorporating both accounting and market data has superior accuracy regardless of the level of institutional quality, indicating that market data may contain complementary information on risk. These results cast doubt on the validity of the conclusions drawn in several previous studies that reject market discipline based on the finding that market-based risk indicators do not correspond well with various standard non-market indicators.

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    This chapter was published in:

  • Jens Forssbæck, 2011. "Divergence of risk indicators and the conditions for market discipline in banking," SUERF Studies, SUERF - The European Money and Finance Forum, number 2011/4.
    This item is provided by SUERF - The European Money and Finance Forum in its series Chapters in SUERF Studies with number 66-1.

    Handle: RePEc:erf:erfssc:66-1

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    Related research

    Keywords: bank risk; risk indicators; subordinated debt; market discipline; panel data;

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    References

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    1. Crouzille, Celine & Lepetit, Laetitia & Tarazi, Amine, 2004. "Bank stock volatility, news and asymmetric information in banking: an empirical investigation," Journal of Multinational Financial Management, Elsevier, vol. 14(4-5), pages 443-461.
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    3. Gropp, Reint & Vesala, Jukka & Vulpes, Giuseppe, 2006. "Equity and Bond Market Signals as Leading Indicators of Bank Fragility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 399-428, March.
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    5. John Krainer & Jose A. Lopez, 2001. "Incorporating equity market information into supervisory monitoring models," Working Paper Series 2001-14, Federal Reserve Bank of San Francisco.
    6. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises," IMF Working Papers 08/224, International Monetary Fund.
    7. Douglas D. Evanoff & Larry D. Wall, 2001. "Measures of the riskiness of banking organizations: Subordinated debt yields, risk-based capital, and examination ratings," Working Paper 2001-25, Federal Reserve Bank of Atlanta.
    8. Sironi, Andrea, 2003. " Testing for Market Discipline in the European Banking Industry: Evidence from Subordinated Debt Issues," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(3), pages 443-72, June.
    9. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," Working Paper Series WP-00-7, Federal Reserve Bank of Chicago.
    10. Hancock Diana & Urs W. Birchler, 2004. "What Does the Yield on Subordinated Bank Debt Measure?," Working Papers 2004-02, Swiss National Bank.
    11. Angkinand, Apanard & Wihlborg, Clas, 2010. "Deposit insurance coverage, ownership, and banks' risk-taking in emerging markets," Journal of International Money and Finance, Elsevier, vol. 29(2), pages 252-274, March.
    12. Douglas D. Evanoff & Larry D. Wall, 2001. "Sub-debt yield spreads as bank risk measures," Working Paper 2001-11, Federal Reserve Bank of Atlanta.
    13. 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.
    14. Sironi, Andrea, 2002. "Strengthening banks' market discipline and leveling the playing field: Are the two compatible?," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 1065-1091, May.
    15. Goyal, Vidhan K., 2005. "Market discipline of bank risk: Evidence from subordinated debt contracts," Journal of Financial Intermediation, Elsevier, vol. 14(3), pages 318-350, July.
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