Is Regulation a Substitute for Market Discipline in Banking - Essay Example

Is Regulation a Substitute for Market Discipline in Banking? Is Regulation a Substitute for Market Discipline in Banking? Market Discipline Market discipline in the banking industry usually refers to the transparency in reporting. This helps to increase the responsibility for the bankers. It makes banks more considerate about the risks and benefits associated with the funding. This concept then further leads to study the responsiveness of the costs of funding to the risks associated with them. Market discipline is dependent on the gathering of the information and the incentives for the collection of such information. It primarily focuses on to foresee the financial markets. Market discipline is categorized as direct market discipline and indirect market discipline. Direct Market discipline has two main components; default risk pricing and governance issues. Default risk-pricing stems out from the debt to equity ratio of the companies. Low capital corporate clients who are limited are more induced to default rather than other clients. Secondly, the governance issues also play a vital role in market discipline. The governance structure and its remuneration strategies should provide incentives to the management for increasing the shareholder value. Otherwise market discipline will collapse due to lack of interest of those who run the affairs of the companies. Indirect market discipline refers to the responsibility of the bankers to sense the risk in the markets by way of market prices. As markets are emerging, more and more risk factors are being developed. Indirect market discipline is normally derived from the prices of the financial instruments (Apanard et al., 2014a). Role of Market Discipline in Banking Market Discipline is primarily responsible for the effective running of the financial markets. Market discipline is not just restricted to the quality of the information disclosed; it also refers to the quality of the information that is input to the banks. In the case of incorrect information being received by the banks, the pricing of the funds is also hurt. Such pricing which is not based on market conditions is the main reason of the failures of the banks. This proves that absence of Market discipline is the main reason of the financial crisis (Apanard et al., 2014b) Why Market Discipline is weak in the Banking Industry Market discipline is weak because much of the default risk is mitigated by insurance. Such insurances deviate the bankers from the risk reduction techniques. Bankers know that their amount is safe. As controls over the debtors get loose, the frequency of the defaults also starts increasing. Implicit guarantees also play a tacit role in weakening of the banking industry. Managers and other stakeholders assume the banks to be ‘too big and too complex to fail’. This perception about the banks makes the bankers a bit more deviant from being risk-averse (Aparnad & Clas, 2013a). This condition is worsened in the countries where fewer banks constitute the major portion of the total financial industry. They are in much healthy position to dominate the regulators. Definitely, regulators came into action as an alternate to the failed market discipline (James et al., 2012). When these big banks are dominating the regulators, then there is no difficulty for them to manipulate the market forces and change the results. Sometimes, governments also provide a minimum level of cushion to the banks in case of defaults. Such relax given by governments also provides comfort to the managers and supervisor. Ultimately, this lead to the failure in market discipline because recovery efforts are reduced towards debtors, which lead to delayed payments in the first instance and then default in second instance. This government relaxation is also a factor that weakens the market discipline in the banking industry. As more funds come in the banks for deposits, the banks invest them in more lucrative ventures. This has made the banks move away from the conventional banking activities towards other non-conventional activities. As new investment ventures come to banks, they bring more risks associated with their particular industry. As bankers are not specialist of those industries, they assess the risks but not to a reasonable extent. This is the factor that dilutes the market discipline in the banking industry (Aparnad & Clas, 2013b). When individual customers are dealt with for financing, the banks normally opt for due diligence assignment. It comprises of analytical procedures that are corroborated with inquiries and limited verification. Due diligence is normally conducted in a short period of time and its scope is much limited than the external audits. Resultantly, the decisions based on due diligences have high risks associated with it due to the limited scope of the verification. This is one of the main causes, which disturb the market discipline in the banking industry. As discussed above, governance structure has a key role to discipline the market. In financial markets, where corporate governance is poor, chances are high that the market discipline will be weak. This is because least interest will be incorporated into the affairs of the banks and their debtors by their respective managements. Governance structure is mainly based upon the rights of the shareholders and creditors. In countries, where the protection of their rights is low, the corporate governance structure is weaker and consequently market discipline is also weak (Penny & Clas, 2012b). Market discipline is also weak because much of the time of the bankers is being served in compliance. As regulations are coming up, bankers and supervisors, both are working on the compliance and its monitoring respectively. This has taken market discipline in the background, which is the main reason of its weakness in the banking industry (Wihlborg, 2011a) Globalization of the banks has played its part in bringing hazard to the market discipline. As banks moved abroad from their native markets, the governments of those countries welcome them. The banks initially misinterpreted this gesture of the governments. It was assumed that the governments will come to rescue in case of default by the debtors, however, it did not happen. This damaged the market discipline. Moreover, foreign loans were mainly given on the third party guarantee. Relying on guarantees also hurt the market discipline as they did not prove well. Absence of international laws did not secure the bank debts. Impact of Regulations on Market Discipline There are different types of regulations being introduced for the banking industry. The regulations related to the governance structure are adding strength to the Market discipline. Whereas, regulations that relate to the financial aspects are weakening the regulations for market discipline. For instance, the requirement for maintaining the ratio of debt to equity will induce the bankers to resort to window dressing. More manipulation will be done to the financial statements for reaching the thresholds given the regulations. (James et al., 2014) Regulatory requirements also hurt the market discipline in the way that bankers pay much more importance to the compliance of the regulation rather than the market discipline. Previously when financial institutions had little or no regulations, the market discipline held them responsible for foreseeing the financial risks. This responsibility made them more careful for running the operations of the business (Clas, 2011). In contrast to previous practices, if banks fail or deteriorate now, the managers feel no responsibility in case they have complied with the regulations. The compliance with the regulations has given them the room to escape from the market discipline. Such impact of the regulations on the market discipline can only be guarded if the regulations reflect the risks of the market. This will require the regulations to be more responsive and changing. Sudden changes in regulations will make it more difficult to be complied with (Wihlborg, 2014). As per the concept of regularization is globalizing, cross boundary regulation has also a role to play. Financial institutions will either move to those countries where regulations are lesser or they will use those countries to prepare more off-balance sheet items in order to meet the capital requirements. All these factors will hurt the spirit of market discipline (George et al., 2007). Regulations are being prepared on a continuous basis, but they are prioritizing some sectors over the others. For example, commercial deposits sector is being hit more rather than leasing sector. This segmentation is demotivating the sectors being hit. This will move the capital from one sector to other. This is eradicating the market discipline from the sectors being hurt. Since the operations are moving from these sectors, this is moving the risk oversight from the sectors regularized more. However, there are certain regulations relating to the disclosure in the annual report, which affects the market discipline in a positive manner. As because of these disclosures, the users become more aware of the performance and the risks coming ahead. However cross boundary banking is the limitation to this advantage. Similar financial institutions follow different standards of reporting in differing countries. In some countries, International financial reporting Standards are used and in some countries, Generally Accepted Accounting Principles are used. This difference in reporting requirements effects the information being presented to the users. Users are unable to absorb the facts disclosed which effects their decision-making and ultimately the indirect market discipline (Apanard & Clas, 2013). List of References Apanard, P. & Clas, W., 2013. Implicit Guarantees, Business Models and Banks’ Risk-Taking through the Crisis: Global and European Perspectives. [Online] Available at: [Accessed 8 April 2014]. Apanard, A., Clas, W. & Thomas, W., 2014a. Market Discipline for Financial Institutions and Markets for. [Online] Available at: [Accessed 8 April 2014]. Apanard, A.P., Clas, W. & Thomas, W.D., 2014b. Market Discipline for Financial Institutions and Markets for Information. [Online] Available at: [Accessed 7 April 2014]. Aparnad, P. & Clas, W., 2013b. Implicit Guarantees, Business Models and Banks’ Risk-Taking through the Crisis: Global and European Perspectives. [Online] Available at: [Accessed 7 April 2014]. Aparnad, P. & Clas, W., 2013C. Implicit Guarantees, Business Models and Banks’ Risk-Taking through the Crisis: Global and European Perspectives. [Online] Available at: [Accessed 7 April 2014]. Clas, W., 2011. Reforming Liquidity Requirements/Pros and Cons of Separate Liquidity Requirements. [Online] Available at: [Accessed 7 April 2014]. George, K., Larry, W. & Gillian, G., 2007. Is Basel II missing the target? [Online] Available at: [Accessed 8 April 2014]. James, B., Apanard, P. & Phillip, S., 2012. Just how big is the too big to fail problem? [Online] Available at: [Accessed 7 April 2014]. James, B., Penny, P. & Clas, W., 2014. (Lack of) Transparency in Financial Regulation. [Online] Available at: [Accessed 7 April 2014]. Penny, P. & Clas, W., 2012. Implicit Guarantees, Governance and Banks’ Risk-Taking through the Crisis. [Online] Available at: [Accessed 7 April 2014]. Wihlborg, C., 2011. Reforming Liquidity Requirements/Pros and Cons of Separate Liquidity Requirements. [Online] Available at: [Accessed 7 April 2014]. Wihlborg, C., 2014. Reforming Liquidity Requirements/Pros and Cons of Separate Liquidity Requirements. [Online] Available at: [Accessed 8 April 2014]. Read More