An empirical investigation of market discipline and bank risk exposure

Khoa Trinh Anh Hoang (2011). An empirical investigation of market discipline and bank risk exposure Honours Thesis, UQ Business School, The University of Queensland.

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Author Khoa Trinh Anh Hoang
Thesis Title An empirical investigation of market discipline and bank risk exposure
School, Centre or Institute UQ Business School
Institution The University of Queensland
Publication date 2011-10-27
Thesis type Honours Thesis
Supervisor Dr Mamiza Haq
Professor Robert Faff
Total pages 109
Language eng
Subjects 1502 Banking, Finance and Investment
Abstract/Summary Due to principal-agency frictions, firms tend to engage in moral hazard behaviour. The banking industry is highly susceptible to the moral hazard problem. The reasons are twofold. First, the opaque nature of bank assets magnifies the information asymmetry condition which makes it difficult for outside investors to reliably assess bank risk profiles. Second, the web of government safety nets distorts the incentives of market participants to less vigilantly monitor and discipline bank risk-taking behaviour. Recurring bank crises, most recently the Global Financial Crisis (GFC) highlights the inherent weaknesses in banking systems around the world, particularly in developed countries in managing excessive risk taking by banks. With a focus on the G7 countries, this thesis empirically examines the impact of market discipline, in the form of uninsured liabilities, on bank risk. The thesis documents five key findings. First, and foremost, the evidence broadly supports the notion that market discipline helps reduce bank equity risk and credit risk. Second, there is some evidence of a convex relationship between market discipline and bank risk, but not in a way that undermines the key result above. Third, the impact of market discipline on bank risk is stronger in the presence of a risk-adjusted insurance premium, a potential source creating moral hazard. Fourth, with the support of bank capital, market discipline can impose stronger influences to help limit banks’ exposure to risk. Finally, there is evidence that market discipline has a greater impact on bank risk in the post-crisis period. This thesis provides evidence which should help weaken the reluctance of bank regulators to encourage market discipline – a reluctance born out of a concern that excessive reaction of the market during bad times can undermine banking stability.

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Created: Thu, 28 Jun 2012, 14:46:09 EST by Karen Morgan on behalf of UQ Business School