Essays on Market Discipline in the Capital Market

Abstract

This thesis consists of two chapters that examine two important issues in commercial banking: market discipline provided by wholesale financiers, and the effect of wholesale funding on the credit supply. I use a panel dataset for US commercial banks between 2002:Q1 and 2012:Q4 to investigate the impact of the 2008 financial crisis on the disciplining role of wholesale financiers. The first chapter analyzes whether wholesale financiers punish banks for taking greater risks by demanding higher interest rates or withdrawing their funds. I focus on the interaction effects of bank-specific risk and market (common) risk on the supply of wholesale funding, in addition to the difference between short-term wholesale financiers (interbank lenders and repo lenders) and long-term wholesale financiers (large time depositors) because investors may have different incentives to monitor banks depending on debt maturity or the strength of government protections. I provide evidence that wholesale financiers behave differently in favorable and unfavorable economic conditions. Both short- and long-term wholesale financiers disciplined risky banks during the pre-crisis period. Specifically, short-term wholesale financiers adjusted both the price and quantity when their borrower banks become riskier, while long-term wholesale financiers disciplined banks only through quantity rationing during stable economic periods. However, neither of them was sensitive to bank risk during the crisis, when the US government implemented extensive rescue programs. This result implies that substantial government support eliminates wholesale financiers incentives to discipline banks. Furthermore, during the crisis, large time depositors seemed to exploit government safety nets by putting more money into riskier banks that provided higher prices. Interestingly, the lack of market discipline continued in the post-crisis period, although the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted in 2010. These results are robust even after controlling for the effect of the Troubled Asset Relief Program, for the quantitative easing policy, and for credit demands of bank borrowers. The second chapter investigates how wholesale funding affects the extent to which banks supply credit to their borrowers depending on macroeconomic conditions. This study has three objectives. First, to determine whether wholesale funding contributed to both the lending boom during the pre-crisis period and the credit contraction during the crisis. Second, to investigate whether riskier banks with more wholesale funds engage in more prudent lending than those with less wholesale funding, based on the disciplinary role of wholesale financiers. Finally, to determine how these banks change their lending behavior depending on market conditions. To this end, I consider risky lending by defining risky lending as increased credit or its risky loan components (short-term loans, real estate loans, and commercial and industrial loans) with higher interest rates on this credit. I find that banks relying more heavily on wholesale funds provided more credit during the pre-crisis period. This result implies that the increase in credit supply by high wholesale-funded banks led to the lending boom, and thus the increased the financial fragility in the banking system during the boom. High wholesale-funded banks, however, cut their lending more significantly during the crisis, suggesting that they contributed to the severe credit crunch. I also find that riskier banks with high wholesale dependence increased risky lending during the crisis and post-crisis periods, though these banks did not pursue risky lending during boom times.