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Article Excerpt
POL1CYMAKERS HAVE SHOWN considerable interest in market discipline as a supplement to bank regulation. The idea is that regulators can use market signals to identify banks that the market perceives as riskier (Berger 1991). (1) Most of the "market discipline" literature has concentrated on using traded subordinated debt and equity pricing as a market discipline tool (Morgan and Stiroh 2001, Sironi 2002, Evanoff and Wall 2001, Ashcraft 2008). In this paper, we take another approach in concentrating on interbank borrowing as a signal of risk.
Interbank exposures have often been viewed in the literature as a source of contagion (Allen and Gale 2000, Freixas, Parigi, and Rochet 2000) and, therefore, as a factor enhancing systemic risk. However, Rochet and Tirole (1996) argue that by generating incentives for lending banks to monitor interbank-borrowing banks, interbank exposures may also contribute to prudent market behavior and reduce the risk of bank failures and systemic distress. The idea is that banks are particularly good at identifying the risks of other banks. Provided with proper incentives, they can perform a complementary task to bank regulation and supervision by the authorities.
Despite the obvious appeal of this idea, empirical research on the issue is limited. In a first step in this direction, Furfine (2001) examines the pricing of interbank lending agreements as an indicator of the ability of banks to monitor their interbank borrowers. Since interbank loans in the federal funds market are large and uncollateralized, they expose lending institutions to significant credit risk. Lending banks, therefore, have an incentive to monitor their counterparties and price these loans as a function of the credit risk of the borrowing bank. (2) Furfine's empirical results support this hypothesis by showing that borrowing banks with higher profitability, higher capital ratios, and fewer problem loans pay lower interest on federal fund loans than others. However, the impact is fairly small; for example, a one standard deviation rise in the loan-to-capital ratio raises the interest rate by merely 1.5 basis points. In a more recent paper, King (2008) also finds that high-risk banks pay higher interest on federal funds. He shows, in addition, that more risky banks will borrow less in the federal funds market. Ashcraft and Bleakley (2006) point to the fact that the studies focusing on the correlation of prices with risk may confound supply and demand effects. To disentangle supply and demand effects they use exogenous shocks to a bank's liquidity position to trace out the credit supply curve. Using this approach, they document only weak evidence of the existence of market discipline.
A potential reason for the small economic significance of the results and the low empirical research interest in the issue is that the economic analysis of interbank exposures has so far concentrated on highly developed banking markets, where interbank exposures are mostly generated by short-term liquidity needs (as modeled by Bhattacharya and Gale 1987). As pointed out by Rochet and Tirole (1996), short-term interbank exposures might not be effective disciplinary tools since they can quickly be abandoned by both the borrowing and the lending banks. Furthermore, in an environment where interbank borrowers are large institutions the disciplining role of interbank borrowing may be hampered by too-big-to-fail concerns, since the interbank lenders anticipate potential bail-outs of the large interbank borrowers.
Our purpose in this paper is to document that interbank borrowing is associated with lower risk taking of borrowing banks. This phenomenon would be consistent with the market discipline hypotheses and with some type of monitoring role performed by the lending banks.
To empirically test this hypothesis we employ data from a sample of Central and Eastern European (CEE) countries, where interbank trade is the result of long-term specialization of incumbent banks in issuing deposits and of new entrant banks in lending to nonbanks. We define banking systems with such a structure as two-tier banking systems. Two-tier banking systems present two advantages for the analysis of the risk alleviating role of interbank borrowing. First, in this environment, interbank lending is characterized by longer maturities than those common in the United States, where interbank loans are usually overnight. (3) Second, interbank borrowing banks are typically small institutions. Therefore, in this context the too-big-to-fail doctrine does not apply for the interbank borrowers and interbank lenders are likely to react to the observed risk of the borrowing bank without counting on being bailed out.
The rest of the paper is structured as follows. Section 1 describes the emergence and the characteristics of the two-tier banking systems in CEE countries. Section 2 presents a short discussion on the relationship between interbank borrowing and bank risk. Section 3 introduces the data sources. Section 4 presents the empirical analysis and Section 5 concludes.
1. BANK SPECIALIZATION AND INTERBANK BORROWING IN CEE
We consider banks from 10 CEE countries with a common past of planned economies. Before we proceed with the empirical analysis, we will present a short overview of the CEE banking market developments that led to the emergence of two-tier banking structures in some of these countries.
The two-tier banking system structure is characterized by high volumes of interbank borrowing from the largest banks, which dominate the deposit markets, by the smaller banks, which together dominate the market for loans to nonbanks. It emerged only in some of the sample countries (Czech Republic, Hungary, Poland, and Slovakia). In other sample countries (Estonia, Latvia, Lithuania, Romania, and Slovenia), new entrant banks dominate both the deposit and the loan market and we observe a classical banking system structure with banks active in both the deposit and the loan market (see Table 1). We include banks from countries with classical banking system structures in order to control for other transition specific effects.
The emergence of the two-tier systems was mainly a result of the design of banking system reforms. It emerged in those countries where governments were unwilling to let incumbent banks fail and undertook massive and repeated recapitalization programs. In the early transition period no explicit deposit insurance schemes existed, but the repeated recapitalization of the incumbent banks provided an implicit deposit guarantee on incumbents' deposits. At the same time, small new entrants were allowed to fail. (4) In the meantime the pool of borrowers rapidly changed in these economies, with the share of small- and medium-sized enterprises constantly increasing. The new banks seemed to be better suited to lend to the small private businesses than the large incumbent banks. (5) As a result, the new entrant banks had a large demand for loans but insufficient customer deposits to finance them, while the incumbents held customer deposits in excess of loan commitments. This was the pattern of banking system transition in Bulgaria (only in the early transition period), the Czech Republic, Hungary, Poland, and Slovakia. In Hungary, for example, the largest incumbent bank, OTP, held 55% of all deposits in 1994 but only 31% of all loans. By 2004, the figures had changed to 26% of all deposits and 16% of all loans. Similarly, in the Czech Republic, Sporitelna Banka held 39% of all deposits in 1994 but only 18% of all loans; by 2004, the deposit market share of Sporitelna Banka had declined to 26%, while its loan market share stayed almost constant at 20%.
A different scenario developed in the Baltic countries, where the incumbents, inherited from the Soviet era, were Baltic branches of Soviet banks. Some of these banks were...
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