Bank Risk Management

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Lecture 5 — Bank Risk Management & Market DisciplineDownload

Lecture 5 — Bank Risk Management & Market Discipline

1. The Simple Balance-Sheet Toolkit

  • Leverage (funding side):
  • (E/A \uparrow \Rightarrow \text{default risk} \downarrow)
  • Equity adjusts slowly (new issues, retained earnings).
  • Deposits move quickly and reflect depositor discipline.
  • Asset mix (asset side):
  • ( \text{Cash/Assets} \uparrow \Rightarrow \text{asset risk} \downarrow )
  • Cutting new lending and holding more reserves/T-bills reduces fragility.
  • Public info channel:
  • Bank examiners audit → balance sheets published in newspapers.
  • Market interprets → depositors reward or punish banks.

2. Visualizing Default Risk (Intuition)

  • Plot Equity/Assets (E/A) vs. asset risk (proxied by loan risk × Loans/Assets).
  • Iso-risk curves:
  • Moving down/right = higher default risk.
  • Moving up/left = safer.
  • Depositors are risk-intolerant:
  • Withdraw when risk rises.
  • Remaining (risk-tolerant) depositors demand higher interest rates.

3. Great Depression Case Study

  • 1929 NYC banks (Point X):
  • E/A ≈ 35% (very high by today’s standards).
  • Cash ≈ 25% of assets.
  • Very low default risk (≈ 1 bp).
  • Shock hits (1929–33):
  • Loan values fall → equity absorbs losses → E/A falls.
  • Perceived loan risk rises → banks shift rightward on graph.
  • Depositors begin withdrawing → shift from banks to postal savings & Canadian banks.
  • Adaptation (Point Z):
  • Banks respond by cutting loans and holding more cash.
  • By 1940: loans = 0.3 × cash (≈ 75% of assets in cash).
  • None of these NYC banks failed, showing market discipline works.

4. Evidence of Market Discipline

  • Chicago (1931–32):
  • Banks that failed in 1932 were already riskier in 1931:
    • Paid 1% higher deposit rates.
    • Had more wholesale deposits (12% vs. 2%).
    • Lost more deposits well before failures.
  • Argentina (1990s):
  • Failing banks paid higher deposit rates (13% vs. 9.5%).
  • Risky banks lost retail deposits, relying on wholesale funding.
  • Mexico (1996):
  • Even with de jure 100% deposit insurance, political uncertainty made depositors skeptical.
  • Banamex paid 17% vs. Serfin’s 29% → reflected perceived insolvency risk.

5. Lessons from Market Discipline

  • Depositors can and do monitor banks.
  • Risk-intolerant depositors exit early, while risk-tolerant depositors demand higher returns.
  • Observable indicators:
  • Deposit outflows.
  • Rising deposit interest rates.
  • Balance sheet shifts (cash vs. loans, equity vs. deposits).
  • Government stats (like loan quality) can be distorted.
  • Deposit flows and pricing are more reliable signals of market discipline.

6. Implications

  • Crises are not purely “panic.” Failures are usually tied to fundamental weakness.
  • Market discipline is a real force shaping bank behavior.
  • Regulatory credibility (audits, transparency) amplifies depositor discipline.
  • Structural fragility (unit banking, pyramiding of reserves) magnifies risks.
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