Bank Moral Hazard and Market Discipline

Financial Markets Group Working Paper No. 0326

Posted: 27 Sep 1999

See all articles by Elena Carletti

Elena Carletti

Bocconi University - Department of Finance; European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS)

Date Written: May 1999

Abstract

We show that market discipline can be effective in resolving the moral hazard problem which arises when depositors do not know whether bankers are monitoring or not the projects they finance. Demandable debt, by allowing the possibility of bank runs, can induce bankers to monitor. However, market discipline comes at a cost. When depositors are not equally informed about the future value of bank assets, withdrawals caused by a liquidity shock may be confused with future insolvency and cause uninformed depositors to precipitate a run. Likewise, withdrawals due to upcoming insolvency may be confused with a liquidity shock and dissuade depositors from running. Bank runs are, therefore, costly and imperfect disciplinary devices for bankers. Our results offer a new perspective on the debate on market versus regulatory discipline of banks.

JEL Classification: G21, G28

Suggested Citation

Carletti, Elena, Bank Moral Hazard and Market Discipline (May 1999). Financial Markets Group Working Paper No. 0326. Available at SSRN: https://ssrn.com/abstract=181200

Elena Carletti (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

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