Understanding the Failures of Market Discipline
82 Pages Posted: 5 Mar 2014 Last revised: 5 Jan 2016
Date Written: March 3, 2014
“Market discipline” — the notion that short-term creditors can efficiently rein in bank risk — has been a central pillar of banking regulation since the late 1980s, both in the United States and abroad. While market discipline did not prevent the buildup of bank risk that caused the recent financial crisis, the conventional wisdom has been that this failure was due to an insufficiency of market discipline, rather than any problems with the concept itself. As a result, policy makers have increased regulatory reliance on market discipline, making this a central part of their reform efforts. This Article challenges the prevailing wisdom and makes two significant contributions to the literature. First, I demonstrate that market discipline failed more severely and completely than has previously been acknowledged, as it did not even identify rising bank risk until after the financial crisis had already begun. Second, I explain the causes of this failure. Market discipline conflates two distinct types of bank-issued securities — investment securities and money instruments — and therefore errs in two critical ways. Market discipline relies too heavily upon investors in money instruments, who are relatively insensitive to risk and thus particularly poor monitors of banks. And market discipline ignores the effects of bank shareholders, who are highly risk-sensitive but may have incentives adverse to those of public policy. Despite these enormous flaws, market discipline continues to be a major point of emphasis among bank regulators and policy makers, increasing the risk that regulators may again be blindsided by another financial crisis.
Keywords: Market discipline, banking, regulation
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