Market Discipline and Bank Risk Taking

Abstract

This paper explores the impact of market discipline on bank risk taking. We examine a broad sample of financial institutions from the G7 nations over the period 1996-2010. We apply System Generalized Method of Moments estimation to control for endogeneity and other unobserved heterogeneity in a dynamic panel setting. Our analysis suggests that market discipline helps reduce bank risk (both equity and credit risk). Moreover, we find that this negative impact of market discipline is stronger: (a) in the presence of a risk-adjusted insurance premium; and (b) during the post-global financial crisis period. However, the disciplinary effect of market discipline is not enhanced in the presence of bank capital. We highlight the policy implications of these findings.

Keywords: bank risk, global financial crisis, market discipline