Academic journal article The Lahore Journal of Economics

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

Academic journal article The Lahore Journal of Economics

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

Article excerpt

Abstract

This study presents empirical evidence of market discipline, using a panel dataset of listed banks on the Karachi Stock Exchange. We construct multiple risk-based 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.

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

JEL Classification: G20, G21.

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Financial markets facilitate capital allocation (and reallocation) from surplus to deficit units by direct financing, and thus contribute substantially to economic growth. Market-based financing is preferred when there are fewer market frictions emanating from various factors including (but not limited to) informational asymmetries, high flotation costs, extreme volatility, speculative behavior, and agency problems. Not surprisingly-given their weak economic systems and inefficient regulatory controls-these inefficiencies are recurrent in almost all emerging economies. Therefore, in many developing countries, indirect financing or financing through a financial intermediary is common as banks, given their expertise, are expected to minimize transaction costs (search and monitoring), adverse selection, and moral hazard problems.

The main disadvantage of indirect financing is that financial intermediaries tend to take excessive risks, which, in an extreme situation, may lead to the systemic failure of the financial system. Commercial banks' probability of failure warrants a prudent supervisory and governance role on the part of the central bank. The financial sector's vulnerability to various risks-credit, market, liquidity, operational, offbalance sheet risks, and others-is critical both for the economy and related stakeholders (depositors, creditors, shareholders, and the government). Systemic risk can have a devastating impact on the financial system, as is evident in almost all banking crises. To safeguard the interests of all related participants, the financial sector is strongly regulated in all economies. This involves monitoring banks' risk activities and ensuring an adequate risk absorption capacity through the functioning of regulatory and monetary authorities who employ various instruments of control, such as capital adequacy, statutory liquidity reserve requirements, and minimum paid-up capital.

Despite the importance of indirect financing, we cannot undermine the need to develop a strong stock market, not only to facilitate the emergence and growth of new firms, but also because they play a disciplinary role. The stock price is the discounted contingent claim on a firm's future prospects. Mathematically, price P(t+1) is a function of discounted cash flows, given the information set F available at time t.

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The stock price formation process reflects investors' perceptions of the future of a firm by evaluating its manager's current actions. If market participants anticipate managerial efficiency, they will place a higher value on the firm; if not, they will penalize the firm for its inefficiencies by requiring higher compensation. …

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