Conference was entitled "Beyond Pillar 3 in International Banking Regulation: Disclosure and Market Discipline of Financial Firms," Proceedings of a Conference Cosponsored by the Federal Reserve Bank of New York and the Jerome A. Chazen Institute of International Business at Columbia Business School, October 2-3, 2003.Bank supervision ; Bank investments ; Financial institutions - Law and legislation

Donald P. Morgan

Frederic S. Mishkin

English

Research Papers in Economics

FRBNY Economic Policy Review / September 2004 3
1.I n t r o d u c t i o n
f the three pillars supporting the emerging international
 bank capital regulation, the third—increased disclosure 
and market discipline of banks—is probably the least 
considered. This pillar’s conceptual base needs a hard look. 
If the rationale for regulating banks is (or was) some market 
failure, can we expect more efficient market monitoring of 
banks now? What has changed? Practical questions need 
answers too. Disclosure of what? Discipline by which market, 
and how? Is market discipline a credible concept in emerging 
market economies around the world, or even in developed 
nations with “bank-centric” financial systems? Does the 
globalization of financial firms make market discipline less 
credible, or more imperative?
The organizers of this conference raised those questions in 
their call for papers. The response came in the form of more 
than forty papers, mostly by academics and central bank 
researchers. The five selected for presentation at the 
conference are published in this volume, along with the 
discussions by researchers and central bankers with expertise 
in the field. While the five papers differed in technique and 
focus, several made a similar, basic point: Market prices of 
bank securities can inform bank supervisors, but only if 
policymakers resolve to close troubled banks promptly, 
without bailing out uninsured investors. In other words, 
if investors can expect regulators to take prompt corrective 
action against troubled banks, regulators can trust investors 
to help identify those banks.
2. Keeping the Pillars Level
Jean-Charles Rochet observes that the three pillars of Basel II 
seem uneven: Pillars 1 and 2—capital requirements and 
examination by government supervisors—have eclipsed 
Pillar 3—market discipline and disclosure—in the Basle 
Committee’s deliberations. Rochet works through a banking 
model that incorporates stylized versions of all three pillars: 
capital requirements are treated as bank closure thresholds, 
supervisors examine banks to verify capital adequacy, and 
market discipline is modeled as mandatory issuance of 
subordinated bank debt. His analysis uncovers several margins 
where the three pillars do or do not reinforce one another. 
Most interesting, from the conference perspective, is the “push 
me-pull me” interaction between supervisor examinations and 
market discipline: the market can help supervisors identify 
problem banks only if supervisors can commit to closing and 
liquidating undercapitalized institutions. If regulators forbear, 
or if they extend insurance to bondholders, Pillar 3—market 
discipline—provides no support to Pillars 1 and 2. 
Donald P. Morgan and Frederic S. Mishkin
The views summarized are those of the presenters and do not necessarily 
reflect the position of the Federal Reserve Bank of New York or the Federal 
Reserve System.
Conference Overview and 
Summary of Papers
Donald P. Morgan is a senior economist at the Federal Reserve Bank of 
New York; Frederic S. Mishkin is the Alfred Lerner Professor of Banking 
and Financial Institutions at Columbia Business School.
O4 Conference Overview and Summary of Papers
Rochet’s model is a continuous-time, asset valuation model 
where the underlying assets drift randomly over time. The 
model is similar to those used in asset and option pricing, 
except in Rochet’s banking version the underlying assets are 
opaque, the assets require monitoring (or else their return 
falls), and their liquidation is costly (because their value is not 
transparent to outsiders). Liquidation occurs when assets hit 
some endogenous lower limit. Given the setup, bank value is 
reduced to two parts: the value of assets net of monitoring costs 
plus the value of the liquidation option. Rochet’s first point is 
that the liquidation limit that maximizes bank value is below 
the break-even point. In other words, it is socially optimal to 
let some valueless banks remain open (for some period) on 
the chance that assets will recover randomly. 
The rest of Rochet’s analysis shows how the optimal 
liquidation limit—a capital requirement, in essence—varies 
with bank liability structure and the regulatory regime, that is, 
the three pillars. First, the author adds deposits and deposit 
insurance (fairly priced). Deposit insurance invites moral 
hazard in his model, but not the usual type: bankers do not shift 
toward riskier assets, they neglect to monitor existing assets. 
Supervisors can prevent this shirking by closing and liquidating 
low-asset banks (where shirking becomes optimal), but 
supervisors have a time-consistency problem: The prompt 
closing of low-capital banks is optimal ex ante, but ex post, 
supervisors are tempted to postpone closing—to forbear—
in the hope that assets will recover. 
Rochet then argues that market discipline, via mandatory 
subordinated debt issuance, can reduce forbearance by 
supervisors. As long as bank regulators can resist bailing out 
uninsured debtholders, Rochet argues, prices on debt securities 
should provide accurate signals that obligate supervisors to 
take prompt corrective action whenever the prices indicate 
that bank assets have hit an “inspection” threshold. He derives 
the optimal inspection threshold, and shows that the corres-
ponding liquidation limit with market discipline is lower than 
the limit without discipline. In other words, the optimal 
closure rule with market discipline moves toward the first-best 
closure rule, thereby reducing the ex post benefits of 
forbearance. 
3. Bank Disclosure and 
Stock Price Volatility
Bankers sometimes argue that increased disclosure would 
make their institution’s stock price more volatile. The paper by 
Ursel Baumann and Erlend Nier suggests the opposite: Banks 
that are more forthcoming on basic balance-sheet items exhibit 
lower stock price volatility.
The authors’ data, from BankScope, indicate whether a 
given bank discloses any information on seventeen items, 
including loans by maturity, loans by type, loans by 
counterparty, problem loans, and problem loans by type.1 
About 600 banks in thirty-one countries over the 1993-2000 
period are covered. The authors investigate the relationship 
between stock price volatility for each bank (within a country) 
and an index of disclosure on all seventeen items, as well as 
disclosure on individual items.
In theory, the sign of the disclosure-volatility relationship 
is not obvious, nor is the direction of causality: volatility might 
affect disclosure, or vice versa. To reduce the risk of reverse 
causality, the authors collapse their data to a cross-sectional 
average for each bank between 1993 and 2000. The resulting 
“between” regressions indicate whether banks that disclose 
more, on average, have higher or lower volatility. As a further 
precaution, they include other variables in their regressions 
that might affect volatility and disclosure.
Baumann and Nier find that higher values of their 
disclosure index are associated with significantly lower stock 
return volatility. Volatility is also negatively associated with 
most of the individual items in the index. Increased disclosure, 
the study concludes, may benefit bankers and bank super-
visors: bankers benefit from lower stock price volatility while 
supervisors receive more accurate market signals from lower 
volatility.
4. Stock or Bond Market Discipline? 
Saying “market discipline” begs the question: which market, 
stock or bond? Large banks issue bonds as well as equity, so 
which price sends the stronger signal about bank prospects? 
The paper by Reint Gropp, Jukka Vesala, and Giuseppe Vulpes 
demonstrates that, as a theoretical matter, signals from the 
bond and equity markets satisfy minimal requirements for a 
useful indicator. Using option pricing formulas, the authors 
show that a distance to default measure, based on equity 
market value and equity volatility, increases with the market 
value of bank assets and decreases with bank leverage and 
equity volatility (as long as market equity exceeds the 
discounted value of debt). They show that subordinated debt 
spreads satisfy the same properties, however, so the question 
remains: which market is more informative, stock or bond? 
It depends, in some sense, on when one asks. For the authors’ 
sample of banks in the European Union (excluding the FRBNY Economic Policy Review / September 2004 5
United Kingdom), equity markets signal rating downgrades 
about six months sooner than do bond spreads.2 As a 
downgrade becomes more imminent, the signal from rising 
bond spreads gets louder.
The authors also investigate how the strength of each signal 
depends on the likelihood of government support for a given 
bank, as measured by support ratings issued by Fitch. Equity 
signals remain informative even for banks that are likely to be 
supported, presumably because the expected support does not 
extend all the way to equityholders, but bond signals lose all 
information for banks where support is expected. Thus, the 
Gropp, Vesala, and Vulpes contribution, like other papers 
presented at this conference, demonstrates that the potential 
for the market to identify troubled banks depends, at least for 
bond markets, on what the market expects of regulators.
5. Market Discipline across Bank 
Regulatory Regimes
By and large, research on market discipline tests whether 
spreads on bank bonds—which are supposedly uninsured—
are correlated with measures of bank risk. It boils down to 
testing whether investors heed bank risk taking. Studies using 
data from the early 1990s onward do find a significant correla-
tion between bank risk and bank bond spreads, but those using 
data from the early 1980s find no such relationship, suggesting 
that investors were heedless of bank risk during that era. 
The paper by Daniel M. Covitz, Diana Hancock, and 
Myron L. Kwast revisits the historical relationship between 
bank bond spreads and bank risk. The distinguishing empirical 
feature of the analysis is its allowance for the endogeneous 
timing of bond issuance. The authors note that banks (like any 
firm) will avoid borrowing in the market when their financial 
condition is weak. Ignoring that sample selection, especially in 
studies of new bond issues, may bias the estimated relationship 
between spreads and bank risk.
The authors estimate a sample selection model over three 
distinct regulatory “regimes” when the treatment of bank 
bondholders (in the event of bank failure) differed substan-
tially. Under the too-big-to-fail regime (1985-87), bondholders 
enjoyed essentially the same guarantees as insured depositors 
and holders of bank CDs. The development of purchase and 
assumption resolution of bank failures (the 1988-92 regime) 
allowed bank regulators to resolve failures without sparing 
uninsured bondholders. That development put bondholders 
at risk of loss. Bondholders’ standing changed again in the 
post-FDICIA regime (1993-2002), but not necessarily one way 
or the other.3 On the one hand, FDICIA compels supervisors to 
take prompt action against undercapitalized banks. Some such 
actions—dividend restrictions, for example—function like 
bond covenants that may protect bondholders vis-à-vis share-
holders. On the other hand, the National Depositor Preference 
Amendment to FDICIA in 1993 reduced the standing of 
bondholders vis-à-vis insured depositors. The net effect of 
FDICIA and its amendment on bondholders, the authors 
argue, is not obvious.
Covitz, Hancock, and Kwast then estimate their selection 
model to test the strength of bond market discipline over these 
three regulatory regimes. They find that bank bond spreads are 
positively associated with bank risk measures during all three 
regimes, even during the too-big-to-fail period. The link 
between bond spreads and bank risk during the too-big-to-fail 
era may have been missed in earlier studies, the authors 
contend, because of sample selection bias. Even so, they find 
that the link between bond spreads and bank risk was consider-
ably stronger during the later purchase and assumption and 
post-FDICIA regimes. In sum, their findings suggest that 
bondholders were monitoring bank risk all along—even 
during the too-big-to-fail period—but market vigilance 
increased after regulatory reforms put bank bondholders at 
risk and on guard. 
6.P r i v a t e  v e r s u s  P u b l i c l y  
Held Banks 
Simon H. Kwan’s paper suggests a potential downside to 
increased market discipline of banks: heightened agency 
problems. Market discipline necessarily entails public 
ownership, which pits owners against managers. Absent 
sufficient motivation from stock options and other 
incentives, managers may choose a “quiet” life with too little 
risk taking and excessive operating costs. Risk aversion by 
self-interested managers is not necessarily bad if it offsets 
the risk-loving incentives created by deposit insurance, but 
excessive costs are wasteful.
Kwan divides bank holding companies (BHCs) into four 
size classes, then categorizes each class according to public or 
private ownership. He compares the performance and risk 
across bank size classes between 1986 and 2000 and in five-year 
windows therein. For the largest BHCs, returns on assets and 
operating costs do not depend on ownership, but for the 
smaller BHCs, returns on assets are lower and operating costs 
are higher for those that are publicly owned. Small public 
BHCs also hold more capital than do small private ones. 6 Conference Overview and Summary of Papers
Kwan takes his findings of lower returns on assets, greater 
operating costs, and higher capital ratios at small public BHCs 
as consistent with basic agency theory: managers who are not 
owners operate more safely, but less efficiently, than managers 
1. The other items are securities by type, securities by holding 
purpose, deposits by maturity, deposits by type of customer, money 
market funding, long-term funding, reserves, capital, contingent 
liabilities, off-balance-sheet items, noninterest income, and loan-loss 
provisions.
who are owners. In wishing for greater market discipline of 
banks, Kwan concludes, policymakers must consider the 
potentially higher agency costs associated with public 
ownership of banks. 
Endnotes
2. The earlier signal is not a free lunch, however: the equity-based 
measure is more volatile than bond spreads, so it requires longer 
monitoring to discriminate reliably between high- and low-risk banks.
3. FDICIA is the Federal Deposit Insurance Corporation 
Improvement Act.
The views summarized are those of the presenters and do not necessarily reflect the position of the Federal Reserve Bank of New York 
or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the accuracy, 
timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in documents 
produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.

Conference overview and summary of papers

http://www.newyorkfed.org/research/epr/04v10n2/0409morg.pdf

Conference overview and summary of papers

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics