MODELING THE COMPONENTS OF MARKET DISCIPLINE
Bank of Greece
Food and Agricultural Organization of the United Nations
and University of Athens
Market discipline has emerged as a complementary tool for banking supervision. Its effectiveness depends on bank disclosure policy and on market participant’s ability to monitor bank riskiness and impose discipline. We develop a game theoretic model where the bank sends a signal about its riskiness to market participants (the stakeholders) and they, in turn, evaluate the credibility of the signal and make inferences about bank soundness. The model takes into account both bank disclosure policy and market participant reaction to disclosure. The outcome of the model indicates that market participants have the ability to monitor risk but lack the ability to impose actions that reflect this assessment. The theoretical conclusion of the model is empirically tested against data from Greek banking sector. A transparency index is developed based on publicly available data and undisclosed supervisory data but the results are contradictory and do not always confirm the theoretical predictions.
Keywords: Market discipline, transparency, bank risk
JEL classification: G18, G21, G28
The authors wish to thank Heather Gibson for helpful comments. The views expressed in this paper are personal and not binding for the respective institutions of the authors. Alexandros Sarris is currently on leave from the University of Athens.
Department for the Supervision of Financial Institutions,
Bank of Greece, 3 Amerikis Street,
10250 Athens, Greece,
Tel.: +30 210 320 5160
Fax: +30 210 320 5400