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.
