The Hindu Business Line : Market discipline can get stuck in Mint Street controls

A FAMILIAR scene in kindergarten classes is a general restlessness of children indulging in all sorts of noisy pranks till the teacher arrives to start, not with words, but with a few thundering thrashes on the table to bring in some discipline. When bank meetings are no different, one could logically expect the central bank to restore sanity, though we do not normally see that happening till things precipitate to a point of no return.

"The effectiveness of market discipline — the strong built-in incentives that encourage banks and financial systems to operate soundly and efficiently — commands much attention today, particularly in the light of recent accounting scandals," says the book Market Discipline Across Countries and Industries, edited by Claudio Borio, and published by The MIT Press (http://mitpress.mit.edu). The book captures the proceedings of a conference sponsored by the Bank for International Settlements and the Federal Reserve Bank of Chicago.

As banking industry and financial markets are growing in complexity, "government regulation seems to grow less effective" and control will have to be through market discipline, notes the book. The preface points out that the Basel Committee on Banking Supervision has introduced market discipline as "the third pillar in the three-pillar prudential framework for banking", to add to capital standards and supervisory review.

Anne O. Krueger's keynote address concedes that governments are tempted to take the easy path — "to resist or ignore unwelcome market pressure, to postpone difficult and unpopular reforms". It would be markets that will make governments "stick to the right path", she adds. Malcolm Knight emphasises that markets can identify "a risky institution in an otherwise healthy financial system". Supervisors can rely partly on market intelligence and market reactions "to spot early signs of distress", he says. So, I guess the Guv must be watching the news to know what's happening in errant banks.

Writing on the roles of auditors, companies and analysts, Susan Schmidt Bies cautions that disclosure is not equivalent to transparency: "Firms need to provide information in ways that allow and encourage investors to process it." Jaime Caruana, while reviewing the New Basel Capital Accord, observes that bank regulators have begun to view markets as an ally to their system of supervision. One doubts if that is true here because chiefs of banking supervision in the RBI become suddenly inaccessible just when their inputs are needed the most.

Market discipline is a complex phenomenon, says Robert R. Bliss: "Regulators want ex ante discipline to minimise the incidence of troubled banks, but they do not want ex post discipline that reduces their options when dealing with a troubled bank." Let me put that complex thing in simple terms with an example: If the RBI is thinking of putting its nominee on the board of a belligerent private bank, they may not tell us till they finish chatting with the more bellicose bank CEO, because we may get panicky otherwise.

Jean-Charles Rochet distinguishes between direct and indirect methods of market discipline. The former has "private investors influencing bank managers" and the latter has `monitoring' instead of `influencing', and is "more empirically relevant", he says. Prudential control too has two aspects, according to him: micro and macro.

For the latter, you need regulators, because "market signals often become erratic during crises" and "markets do not deal efficiently with aggregate shocks of sufficient magnitude".

Hal S. Scott wants to discipline both creditors and debtors. How? "Creditors should be disciplined by uncompensated losses and debtors should be disciplined by creditors exercising their rights." This would lead to fewer defaults and cheaper credit, he argues. Overly prescriptive regulation can discourage creativity and destroy value, writes Kostas Tsatsaronis; an unclear policy framework too can be a source of uncertainty. Let us do more research on what goes on inside the `black box' of market discipline, exhorts Reint Gropp. "Market discipline of banks should be closely related to the balance of power between the different stakeholders," he adds. It is this balance that can help the bank "take the socially optimal amount of risk". There is a danger, therefore, when power gets skewed.

From Mitsuhiro Fukao's paper you'd learn about the weak market in Japan. For those complaining about low interest rates on FDs, it would help to know that interest rates on time deposits in Japan are "very close to zero", so depositors "do not mind keeping most of their deposits in payment accounts". As an effect of this, "pressure for restructuring among banks" has weakened. A paper on emerging economies draws a line between idiosyncratic risk and systemic risk thus: "Market responses to idiosyncratic risk can truly discipline bank managers, forcing them to run sound banks with healthy fundamentals. However, market responses to systemic risk may at times be independent of the soundness of bank fundamentals." The first risk would be more when a bank chairman is also its CEO, as in many cases, so his whims get amplified as eccentric trajectories for the bank he heads.

David T. Llewellyn advises stakeholder monitors (SHMs) against following a herding behaviour as their banks. "SHMs need to adjust rationally to market signals and not be subject to the same errors, misperceptions, myopia, or false analysis as the banks themselves."

Moral: Don't pack the AGM with only yes-men. Kristin J. Forbes argues against capital controls because they are "mud in the wheels of market discipline", crating "microeconomic distortions and inefficiencies that can substantially reduce long-term growth rates."

The book includes papers on market discipline in other industries such as insurance, and offers suggestions for policy and better corporate governance. In essence, this is a book for bankers who don't want to stick their heads into sand and keep imagining that everything is okay.

Economics@TheHindu.co.in

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