Taking Firms and Markets Seriously: A Study on Bank Behavior, Market Discipline, and Regulation

Abstract

We argue that accounting for the behavior of firms and markets is important for understanding the extent and form and the effectiveness and efficiency of government regulation, particularly in economic policy. We examine the US banking sector and its regulation in the 1990s to gain insights on how studies along these lines could be constructed. We begin by observing that US bank capitalization exceeds governmental capital adequacy requirements by a substantial margin. This observation suggests that banks must also have reasons other than government intervention for selecting high levels of capital. We focus on the main alternative driving force to government regulation, market discipline, and in particular the effect of bank capital on banks' borrowing costs. We find that better capitalized banks have indeed experienced lower borrowing costs. But we also find that, while competitive pressure can help in mitigating the bank solvency problem, it cannot not fully counter free riding of unhealthy banks on a well-capitalized banking sector. These results show that recent US and international (Basel Accord) regulatory reform efforts, which are designed to increase transparency and enhance competition in the banking sector, can be interpreted as an effort to align market forces and regulation in ways that minimize the need for costly government enforcement or bailouts.

Keywords: government regulation, market discipline, banking sector, capital adequacy