The New Basel Capital Accord recognises that market discipline (Pillar III) has the potential to reinforce minimum capital standards (Pillar I) and the supervisory review process (Pillar II), and so promote safety and soundness in banks and financial systems. A number of studies in the context of developed financial system find support for this complementary relationship. However, one important question that can be raised in this context is the extent to which market can be relied upon to act as an effective disciplinary force in the immature financial markets dotting the developing economies, including India. This paper addresses this issue by examining the behaviour of the bank depositors in India. More specifically, it attempts to ascertain whether depositors respond to changes in bank fundamentals, both in terms of deposit held with a bank as well as interest received on it. Considering that a bank's ability to change interest rates (in addition to bank fundamentals) may also influence depositors' willingness to hold deposit with the concerned bank, a possibility arises that depositors' reaction and banks' response (in terms of interest rate payable on deposits) may be a jointly determined process. To account for this dynamic process, the Arellano-Bond dynamic panel generalised methods of moments (GMM) estimation method is employed. The results fail to find any significant evidence of discipline being exerted by the bank depositors. This highlights the limitations of relying on market forces as a disciplinary mechanism in cases of underdeveloped financial systems and the necessity to maintain a high capital standard as well as a vigilant and strong supervisory process.

'Bank Depositors' Role as a Disciplinary Force in Indian Banking: a Dynamic Panel Approach

Though Basel II has been adopted by many emerging economies and guidelines on Market Discipline have been issued, question may be raised as to what extent market can act as an effective disciplinary force in these immature financial markets. This paper examines risk sensitivity of Indian banks' subordinated debt (SND) spreads (primary market) to ascertain whether debt investors act as a disciplinarian by discriminating across banks based on risk. A unique dataset of SND issues is compiled from issue documents filed with National Stock Exchange (NSE) at the time of issue/listing. The dataset includes issues listed with NSE as on 31st August 2007 and covers the period March 1999 to July 2007. Significant issue clustering in the highest rating-low risk categories is observed, both in terms of number and aggregate issue size. The pooled panel OLS results suggest sort of equi-spread clustering along the rating scale giving rise to a step-wise weakly monotonous increase in spread with enhanced issue risk. Dominance by government owned Public sector banks (PSB) in the SND market considerably weakens market discipline. The spread on PSB SND issues are generally lower relative to Private issues in the same rating scale. Even though more than half of the SNDs were issued over the last 28 months of the data period, no increased risk sensitivity of spreads is noticed. Issue ratings perform better as risk proxy relative to accounting measures of risks. Overall, market disciplinary role of the Indian SND market participants proves to be rather weak.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1329003_code443600.pdf?abstractid=1329003

L. M. Bhole

Papers

A Study of Market Discipline in Indian Banking: Role of Subordinated Debt Market