Market Discipline: The Next Generation

My forthcoming article, Interbank Discipline, draws attention to the important role that banks play monitoring and disciplining other banks.  To understand the significance of interbank discipline, the Article proposes a new way of thinking about market discipline more generally.  In the first wave, advocates of market discipline viewed it as a basis for deregulation.  Why expend government resources duplicating the efforts of market participants, the rationale went, particularly considering that regulation can discourage market discipline and markets are often more effective than regulators?  The 2007-2009 financial crisis, and numerous scandals preceding it, largely brought an end to such reasoning.  The Crisis revealed the magnitude of the discrepancy between market participants’ interest in maintaining a stable financial system and the societal benefits of such a system.  The Crisis further revealed that market participants—just like regulators—do indeed make mistakes.  The response, however, overshoots in the opposite direction.   As reflected in the myriad delays in implementing the Dodd-Frank Act, regulators are overwhelmed.  They simply do not have the resources and expertise necessary to assume full responsibility for maintaining an efficient and stable financial system.

The Article introduces a new approach.  It proposes using market discipline as a guide in determining how we can best allocate inherently finite regulatory resources.  Rather than casting market discipline as a uniform force operating for good or evil, it reveals market discipline to be an array of forces, including some that promote socially valuable goals and some that run counter to society’s interest.   Recognizing further that market participants and regulators have different institutional advantages, it suggests that policymakers should seek to understand market discipline, with the aim of harnessing its positive effects and counteracting those that are socially suboptimal.

The Article explores the different dimensions of market discipline through a close examination of the discipline that banks impose on one another.  In so doing, it also draws attention to an important source of market discipline that has gone relatively unexamined in the literature.  It shows that as a result of the fundamental transformation of banking that has occurred in recent decades, banks today are more interconnected than ever.  This gives banks strong economic incentives to understand risk taking at other banks and mechanisms through which they respond when another bank changes it risk profile.  Banks also enjoy a number of institutional advantages, including access to information and expertise, suggesting that they might be particularly good at understanding and evaluating the risk exposures of other banks.

The effects of interbank discipline are decidedly mixed.  The good news is that other banks have self-interested reasons to penalize a bank when it assumes excessive risks, thereby discouraging such risk taking.  The bad news is that the self-serving interests of banks can also lead to socially suboptimal outcomes.  As we have long understood, interbank discipline can be excessively harsh in times of crisis, contributing to the need for a central bank that can serve as a lender of last resort.   Less well understood is that market discipline may also encourage problematic behavior outside of crisis periods.  The primary way market discipline may incent socially suboptimal behavior is by rewarding banks for changing their profiles in ways that increase the probability that they will be bailed out.   The Article shows that in addition to rewarding banks for becoming too-big-to-fail, banks may also play a particularly powerful role encouraging and facilitating banks’ becoming too-interconnected-to-fail and too-correlated-to-fail.

The Article concludes by addressing the policy implications of the rise in interbank discipline.  It suggests that we should rethink bank examination priorities in light of the effects of interbank discipline.  By analyzing the relative institutional competence of banks and bank examiners, the Article suggests that we should reduce the resources devoted to activities that banks are performing well and increase the resources devoted to activities that bank regulators are particularly well suited or incented to undertake.  The Article also considers other policy responses, including ways to better utilize the information created by the interbank market, and it suggests that it may be time to fundamentally rethink the purpose of bank examinations in light of interbank discipline and the transformation of banking underlying its rise.

The full Article can be found here.

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