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Market Discipline in Commercial Banking: Evidence from the Market for Bank Equity

Ayesha Afzal and Nawazish Mirza ()
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Nawazish Mirza: Lahore School of Economics, Pakistan

Lahore Journal of Economics, 2011, vol. 16, issue Special Edition, 233-254

Abstract: This study presents empirical evidence of market discipline, using a panel dataset of listed banks on the Karachi Stock Exchange. We construct multiple riskbased measures from the stock prices between 2004 and 2009 to determine whether an increase in the risk profile results in an increase in compensation for depositors and other creditors. The risk variables used include market risk, value at risk, size and value premium, default likelihood indicator, price relatives, and a control variable representing gross domestic product growth. We find a significant relationship between our risk factors and cost of deposits, indicating that banks align deposit compensation with their risk perception. However, we cannot find a link between the market perception of risk and deposit switching. These findings have important implications for policymakers as market discipline could complement the state’s regulatory role and lower the cost of supervision. Our estimations of value at risk and the default likelihood indicator using stochastic simulations is a methodological contribution that could be used for effective risk management practices.

Keywords: Market Discipline; Karachi Stock Exchange; Value at Risk; Default Likelihood Indicator. (search for similar items in EconPapers)
JEL-codes: G20 G21 (search for similar items in EconPapers)
Date: 2011
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