Market discipline and bank risk through new regulations: evidence from Asia–Pacific

Abstract

PurposeThe purpose of this study is to show the presence of market discipline and provide an explanation for bank risk nondisclosure behavior, specifically market risk (MR), credit risk (CR), operational risk (OR) and counterparty credit risk (CCR). The response of market discipline when banks comply with Basel III capital and liquidity restrictions is also investigated in this study.Design/methodology/approachThe study used the Lasso regression method to give accurate results with the lowest error when using small observational data with a large number of features.FindingsFirst, theoretically, the study points to the presence of market discipline and its sensitivity to the risks disclosed by the bank, especially when applying capital regulations under Basel III. In addition, the study also shows differences between the developed and emerging countries in the sensitivity of market discipline to factors when considering banking regulations. Finally, an interesting result that the study shows is that the higher the index of economic freedom, the weaker the market discipline is, especially for emerging countries.Practical implicationsThe study’s findings have several important implications: (1) help regulators devise policies to manage banks' risk and meet liquidity and capital requirements according to the Basel III framework. The effectiveness of market discipline is reduced, and banking regulators need to compensate by strengthening their supervisory functions. (2) Showed the reasons why banks ignore the disclosure of bank risks according to the provisions of the third pillar of the Basel III framework. Because when following the Basel III framework, depositors demand higher interest rates or increase market discipline towards riskier banks.Originality/valueThis study is the first attempt to assess market discipline under the new capital and liquidity regulations using the Lasso regression model as suggested by Tibshirani (1996, 2011), Hastie et al. (2009, 2015). This is also the first study to look at the impact of four different forms of risk on market discipline (as required by the Basel regulatory framework to improve disclosure).