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Measuring Market Discipline in New Zealand

Cameron Haworth, Liam Gillies, Tobias Irrcher

Non-Technical Summary

Market discipline is a key pillar of the regulatory framework for prudential regulation in New Zealand, yet comparatively little empirical work has been done on how market discipline manifests itself in the marketplace. The purpose of this paper is to measure how market discipline operates among banks in New Zealand.

To our knowledge, this is the first study of its kind in New Zealand, at least in recent years. We hope that we have set a base for more studies in this area to be carried out and we include thoughts on how to enhance the measurement of market discipline in New Zealand. It is our intention to extend the present work but we also invite other researchers to contribute to this effort.

We employ methods commonly used overseas to measure market discipline, as well as a few novel measures mostly relating to how media interacts with market discipline. There are limitations to our data and our results should be interpreted with caution. While this paper focuses on banks, it also includes some tentative work on insurers.

To measure the risk sensitivity of bondholders, we use bond spreads (here calculated as the return on a given bank’s bonds less the return on New Zealand Government-issued 10-year bonds). Our results indicate that bank bondholders respond to balance sheet risk indicators and idiosyncratic risk events in the expected way. That is, bond spreads rise when these indicators signal an increase in risk and vice versa. We cannot characterise the response of depositors to changes in bank risk, because we lack data on both deposit volumes and account switching between banks.

Unfortunately, we are very limited in terms of the analysis we can do on the movement of equity prices and the reaction of shareholders in New Zealand. As is commonly known, our main banks are owned by Australian parent banks and only one bank, Heartland, listed on the New Zealand stock market. Based on the limited analysis we were able to do, we conclude that shareholders did react in a manner that is in line with the theory on market discipline prior to a change in the ownership structure of the bank. Since the change in the ownership structure, the picture has become less clear. We caution against drawing any strong conclusion from this evidence.