FRBSF Economic Letter
2002-36; December 13, 2002
The Promise and Limits of Market Discipline in Banking
A key issue on the agenda for bank regulators is how to leverage market
discipline to supplement their supervisory efforts. For example, in the
recently proposed revision of the Basel Capital Accord, market discipline
is one of the three pillars, along with capital regulation and supervision,
of the structure for safeguarding the banking system.
The rationale for and practice of safeguarding the banking system have
a long history in the U.S. The rationale is that banking firms are special
in a number of ways. They perform certain unique functions in the financial
system, such as providing backup liquidity to the economy and serving
as one of the channels for the transmission of monetary policy. Because
of their specialness, and because banks are subject to "runs"
on their deposits, the government provides deposit insurance and discount
window borrowings as a safety net for the banking system. Motivated by
the desire for financial stability, and the protection of the safety net
from abuses, the government imposes an extensive set of regulations on
banks and subjects them to prudential oversight. Regulation and supervision
of banks is an integral part of the financial architecture.
Indeed, among all industries, the banking industry is arguably one of
the most tightly regulated. Banks are subject to restrictions on ownership,
organizational structure, permissible activities, maximum leverage ratio,
and lending practices. In addition to banking regulations, regulators
employ a large army of personnel engaged in prudential supervision. These
include "resident" examiners who are posted full-time in some
of the larger banks, examiners who go on-site, usually once a year, to
conduct bank examinations, and analysts who perform off-site surveillance
on a regular basis.
The idea of leveraging market discipline to supplement these supervisory
efforts is by no means new. As the Chairman of the Federal Reserve System,
Alan Greenspan, has remarked, "the real pre-safety-net discipline
was from the market, and we need to adopt policies that promote private
counterparty supervision as the first line of defense for a safe and sound
banking system" (2001). This Economic Letter discusses the
promises and limits of market discipline in banking.
The promise of market discipline
In addition to the monitoring that regulators do, there are other sources
of monitoring for banks. One is a corporate governance structure, which
helps suppliers of finance to the bank assure themselves of getting a
return on their investment. The typical governance structure includes
oversight by the board of directors, timely disclosure of all relevant
information to investors, and sets of covenants in the firm's contracts
with different claimants, such as its bondholders. Another source is market
participants, who continuously monitor to protect their own financial
interest in the firm. Their collective actions of buying and selling a
bank's securities in the financial market provide an independent assessment
of the bank's financial condition. In addition to securities holders,
other market monitors specific to banks include uninsured depositors and
counterparties in financial transactions, such as swaps and repurchase
agreements.
There are two types of market discipline: direct and indirect. Direct
market discipline refers to the control or influence all of these market
participants have over a bank's behavior, including decisions on investment,
financing, and operations. Direct market discipline is exerted through
a risk-sensitive financial instrument when a banking organization's expected
cost of issuing that instrument changes with the firm's risk profile.
To the extent that banks must issue debt on a fairly regular basis, direct
market discipline often is thought of as exerted by debtholders rather
than by stockholders. Indeed, debt claims are in better alignment with
the claims on the deposit insurance fund than equities and, hence, are
more consistent with the regulator's goal in exerting direct market discipline.
Indirect market discipline is pricing information from both the primary
and the secondary markets of securities issued by the banking organization
that provides a signal of the firm's risk level. When those market signals
reflect an assessment of increased bank risk-taking, potential investors,
uninsured depositors and liability holders, and other counterparties of
the banking organization will demand higher returns on other bank instruments
or additional collateral for certain credit transactions. If the level
of bank risk-taking indicated by the market signal cannot be tolerated
by market participants, they may limit their risk exposure by refusing
to deal with the bank. Such signals also can be useful to regulators to
assess the firm's risk level.
Among debt securities, some observers argue that subordinated notes
and debentures (SNDs) are particularly well suited to exert both direct
and indirect market discipline because they constitute one of the most
junior of all bank debt instruments (see Federal Reserve 1999); that is,
they are among the last debtholders in line to be made whole if the bank
runs into trouble. As such, SND holders likely view a bailout in the event
of bank failure as highly improbable, a view that is less likely to be
held, for example, by uninsured depositors. Depositor preference laws
also reinforce such views. Moreover, the conjunction of the Basel capital
standards and current market practices have led to SNDs having quite a
long maturity relative to other bank liabilities. Together, the long maturity
and the junior status of SNDs suggest that their yields should be more
sensitive to the perceived risk of the issuing banking company than yields
on other liabilities.
For indirect market discipline, the signaling information from bank stocks
has two advantages over the signaling information from bank debt securities.
One advantage is data availability. Currently, the number of banking organizations
that issue debt publicly, including both SNDs and Certificates of Deposit
(CDs), is relatively small compared to the number that have publicly traded
equities. The second advantage is data quality. Because the market for
bank equities is more liquid and is covered by more professional analysts
than the market for bank debt, stock prices tend to be more efficient
than bond prices in reflecting firm-specific information. So, in terms
of data availability and data quality, bank stocks are clearly better
than bank debt for indirect market discipline. Market participants and
regulators have been extracting information about bank risk from stock
prices on a regular basis.
Limits and related policy concerns
While the concept of market discipline is promising, a number of practical
concerns require careful consideration. At the top of the list is its
impact on risk-taking. The intent of direct market discipline is to constrain
a bank from taking on too much risk because the market imposes higher
financing costs on riskier transactions. However, a profit-maximizing
bank can be expected to trade off risk and return at the margin. Thus,
higher financing costs would not necessarily constrain risk-taking per
se if those costs could be fully compensated by a higher risk-adjusted
return. So, a better way to think about direct market discipline is that
the banking firm's financing costs would constrain it only from taking
risk that is not properly priced. From this perspective, the usefulness
of direct market discipline to banking regulators may be limited if the
objective is to constrain risk-taking rather than to assess whether the
risk is properly priced. This applies to the pricing of both debt and
equity.
Next on the list is the relative scarcity of SNDs in the hands of market
participants. This limits the value of SNDs in indirect market discipline-that
is, in providing accurate signals to regulators about a bank's risk profile.
Most of the SNDs issued by banks are held by the parent holding company
and are not traded publicly. The few SNDs that are traded publicly are
issued by bank holding companies rather than by banks. To the extent that
banking regulators should be more concerned about the safety and soundness
of the bank than of the holding company, market signals from the holding
company's financial instruments would be inherently noisy, depending on
the level of nonbanking activities in the banking organization. Moreover,
targeting SNDs that are issued by bank holding companies may give the
impression that banking supervisors also are concerned about the safety
and soundness of the holding company, which might suggest to the market
that the bank safety net also extends to the holding company's nonbank
subsidiaries.
To address the relative scarcity of publicly traded bank SNDs, policymakers
have proposed ways to increase banks' issuance of them. In fact, the Gramm-Leach-Biley
Financial Modernization Act of 1999 contains provisions that require large
banks to have at least one issue of "high-quality, unsecured public
debt outstanding," which essentially amounts to an SND. The Federal
Reserve has studied the costs and benefits of a policy that includes,
among other options, a mandatory requirement for the very large banks
to issue SNDs on a regular basis (see Federal Reserve 1999). Over the
years, a number of banking observers also have proposed SND policies that
are even more ambitious, including one that calls for a rate cap on bank
SND yields to limit bank risk-taking, and another that allows more SNDs
to be counted as bank capital in meeting regulatory capital requirements.
However, a mandatory SND policy could be quite burdensome to banks, so
it is not surprising that such a policy has been enacted only in a very
limited way in Gramm-Leach-Bliley. As an alternative that would keep the
focus of market discipline on banks rather than on the parent company,
it may be useful to examine some other bank-issued financial instruments,
such as large negotiable CDs. Currently, a number of large banks regularly
issue large CDs that are traded in the money market. Although these instruments
tend to have shorter maturity and are more senior than SNDs, their yields
nonetheless respond to the underlying risk of the issuing bank rather
than the holding company.
The third limiting issue is that market discipline works only for banks
that issue publicly traded securities-that is, it works only when market
prices are available. Thus, market discipline would not be applicable
to community banks and small regional banks that do not issue these securities.
This may be a minor issue, since one of the driving forces for embracing
market discipline is to address the growing complexity of large banking
organizations that could have systemic implications. Currently, all of
these large complex banking organizations have some form of publicly traded
securities outstanding.
Finally, in order for market discipline to be effective, investors must
have timely and accurate information. This requires a high degree of transparency
and an effective disclosure policy at banking organizations. Policymakers
are keenly aware of these requirements and are actively pursuing policies
to enhance transparency and to improve disclosure in banking.
Conclusions
Market discipline in banking is necessary to limit the scope of the
federal safety net. The idea is particularly attractive in light of the
growing complexity of banking organizations. Market discipline is exerted
when the pricing of bank securities reflects the bank's true underlying
risk, which can limit bank risk-taking directly, through the debt issuance
channel, or indirectly, when the secondary market prices convey to market
participants and banking supervisors the true risk of the bank. However,
the integration of further market discipline into the supervisory framework
is not an absolutely straightforward proposition. In moving forward, policymakers
must ensure that they limit the bank safety net so as to convince bank
investors that their investments are at risk. In addition, they need to
recognize that the market may not limit bank risk-taking per se but may
simply price securities commensurate with their risk. Other policy considerations,
such as the choice of financial instruments and efforts to improve transparency
in banking are also crucial for making market discipline an effective
supplement to U.S. bank supervision and regulation.
Simon Kwan
Research Advisor
References
[URLs accessed December 2002.]
Federal Reserve System. Study Group on Subordinated
Notes and Debentures. 1999. "Using
Subordinated Debt as an Instrument of Market Discipline." Staff
Study 172, Board of Governors of the Federal Reserve System.
http://www.federalreserve.gov/pubs/staffstudies/1990-99/ss172.pdf
Greenspan, Alan. 2001. "The
Financial Safety Net." Remarks to the 37th Annual Conference
on Bank Structure and Competition of the Federal Reserve Bank of Chicago,
Chicago, IL (May 10).
http://www.federalreserve.gov/boarddocs/speeches/2001/20010510/default.htm
|
