Academic journal article East Asian Economic Review

Market Discipline and Bank Risk Taking: Evidence from the East Asian Banking Sector

Academic journal article East Asian Economic Review

Market Discipline and Bank Risk Taking: Evidence from the East Asian Banking Sector

Article excerpt

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Regulation and supervision in banking is intended to protect retail depositors and avoid the substantial welfare costs associated with bank failures. Nevertheless, deriving optimal regulation in the banking industry is not an easy task due to the costs involved, political pressure or interest group pressure. In light of these considerations, market discipline is highlighted as one of the key areas of the reform policy in the banking sector. The recent financial crisis highlights the problems of moral hazard and asymmetric information which are rampant in the banking sector. In line with this, the reforms proposed in the Basel III require banks to provide a more relevant and timely information to the stakeholders that enable them to better assess banks' overall capital adequacy and risk profile. Greater disclosure not only improves prudential regulations but more importantly it facilitates effective market discipline. This shows that issues related to market discipline in banking sector are important and remain relevant in the era of Basel III.

Market discipline involves monitoring and influencing by investors (Bliss and Flannery, 2002). Monitoring refers to the investors' capability of assessing a firm's actual situation and sending market signals to the managers. However, it is a necessary but not sufficient condition for market discipline (Bliss, 2004). For market discipline to be effective, it must involve influencing. This happens when bank managers respond to investors' feedback that is reflected in their withdrawal actions or price movements by making more conservative decisions and safer investments (Goldberg and Hudgins, 2002). In this case, Greenspan (2001) asserts that market discipline acts as a 'private counter party supervision' in the banking sector that enables stakeholders to safeguard their interest against excessive risk taking by banks. This present study aims to analyze the effectiveness of market discipline in limiting banks' risk taking behavior. More specifically, it aims to find if market discipline provides banks with the incentive to hold adequate amount of capital as a cushion against potential future losses that may arise from their risk exposure.

Most of the empirical studies have tested the effectiveness of market discipline by focusing on the monitoring aspect. In the context of East Asia, studies by Hosono et al. (2005) and Hamid (2014) confirm that depositors discipline banks by withdrawing their funds from the weaker ones. Nevertheless, with the exception of Nier and Baumann (2006) and Wu and Bowe (2010), not many studies have empirically tested the ability of market discipline in influencing banks' risk taking behavior. The latter study is focused on China while the former is focused on developed countries. This paper complements the existing literature by carrying out similar analyses on the East Asian banks. The findings of this study can be used to identify whether market discipline tools are effective in encouraging greater prudence among bank managers. In addition, the findings can also identify under what circumstances market discipline becomes more effective. This will give us a better perspective about how the role of market discipline can be enhanced so that it can facilitate in reducing the social cost associated with bank supervision.

In this paper, we study the extent to which market discipline exists in the East Asian banking sector. This banking sector is chosen for a number of reasons. Firstly, banks have traditionally played a very important role in the East Asian economies. Banks in the region have undergone rapid liberalization, financial crisis and reform during the period studied. This study aims to examine whether the changes that have taken in the banking system have influenced banks' risk taking behavior. More specifically, given the fact that many bank failures happened during this period and large amounts of public funds were used to bail out weak banks (Hamid, 2013), this study aims to examine if market discipline was effective in influencing banks' risk taking behavior during this period. …

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