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

Forssbaeck, Jens LU (2011) In SUERF Studies 2011/4.
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... (More)
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 favorable. 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. (Less)
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author
organization
publishing date
type
Book/Report
publication status
published
subject
keywords
panel data, market discipline, risk indicators, subordinated debt, bank risk
in
SUERF Studies
volume
2011/4
pages
58 pages
publisher
SUERF, European Money and Finance Forum
ISBN
978-3-902109-59-0
language
English
LU publication?
yes
id
1ceffd96-a9b9-47cf-8d19-1e041a710039 (old id 3362976)
alternative location
http://www.suerf.org/download/studies/study20114.pdf
date added to LUP
2013-01-15 08:23:12
date last changed
2016-04-16 08:19:34
@misc{1ceffd96-a9b9-47cf-8d19-1e041a710039,
  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 favorable. 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.},
  author       = {Forssbaeck, Jens},
  isbn         = {978-3-902109-59-0},
  keyword      = {panel data,market discipline,risk indicators,subordinated debt,bank risk},
  language     = {eng},
  pages        = {58},
  publisher    = {ARRAY(0x94f86c8)},
  series       = {SUERF Studies},
  title        = {Divergence of risk indicators and the conditions for market discipline in banking},
  volume       = {2011/4},
  year         = {2011},
}