Depositor discipline and the banking panic of 2023

• Published date: 01 June 2023
• Author: Paul Kupiec
• Date: 01 June 2023
• DOI: http://doi.org/10.1111/jacf.12571

DOI: 10.1111/jacf.12571

ORIGINAL ARTICLE

Depositor discipline and the banking panic of 2023

Paul Kupiec

American Enterprise Institute, Washington,DC, USA

Correspondence

Paul Kupiec c/o American EnterpriseInstitute 1789 Massachusetts Avenue NW Washington, DC 20036.

Email: paul.kupiec@aei.org

INTRODUCTION

There is a significant body of academic literature supporting the

hypothesis that short-term creditors, including uninsured depos-

itors, play a significant role in moderating bankers’ appetite for

taking risks. This literature, which mostly predates the Great

Financial Crisis, argues that short-term creditors can impose mar-

ket discipline on banks if they: (1) have the ability to monitor

and assesses the risk profile of a bank; and (2) take actions that

cause bank management to respond to short-term creditors’ risk

assessments.1

Short-term creditors are a source of market discipline when

they systematically identify risky bank behavior and charge higher

interest rates and limit credit to banks with elevated risk pro-

files. To the extent they do, bank managers must anticipate the

inevitability of elevated funding costs when evaluating the prof-

itability of a risky business venture. Though as yet untested in

this literature, short-term bank creditors would not only have to

charge higher interest rates but correctly price a bank’s risk to

function as an efficient source of discipline on bank risk-taking.

For the most part, academic studies have concluded that short-

term bank creditors who face losses in the event of bank insolvency

charge higher rates and limit their exposures to at-risk banks.2

1See for example Calomiris, Charles, and Charles M. Kahn. 1991. “The Role of Demand-

able Debt in Structuring Optimal Banking Arrangements.” American Economic Review 81:

497–513; Flannery, Mark J. 1994. “Debt Maturity and the Deadweight Cost of Leverage:

Optimally Financing Banking Firms.” American Economic Review 84: 320–331; Flannery

Mark J. 2001. “The Faces of ‘Market Discipline’.” Journal of Financial Services Research 20:

107–119; and Bliss, Robert R., and Mark J. Flannery.2002. “Market Discipline in the Gov-

ernance of U.S. Bank Holding Companies: Monitoring vs. Influencing.” European Finance

Review 6: 361–395.

2See among others, Baer, Herbert, and Elijah Brewer III. 1986. “Unsecured Deposits as a

Source of MarketDiscipline: Some New Evidence.” Economic Perspectives 10; Park, Sangkyum,

and Stavros Peristiani. 1998. “Market Discipline by Thrift Depositors.” Journal of Money,

Credit, and Banking 30(No.3): 347–364; Goldberg, Lawrence G., and Sylvia Hudgins. 1996.

“Response of Uninsured Depositors to Impending S&L Failures:Evidence of Depositor Dis-

cipline.” Quarterly Review of Economics and Finance 36(No. 3): 311-325; Hannan, Timothy,

and Gerald A. Hanweck. 1988. “Bank Insolvency Risk and the Market for Large Certificates

of Deposit.” Journal of Money, Credit,and Banking 20: 203–212; Cargill, Thomas G. 1989.

“CAMEL Ratings and the CD Market.” Journal of Financial Services Research 3: 347–358;

Keeley, Michael C. 1990. “Deposit Insurance, Risk and Market Power in Banking.” Ameri-

can Economic Review 80: 1183–1200; and Furfine, Craig. 2001. “Banks as Monitorsof Other

Banks: Evidence from the Overnight Federal Funds Market.”The Journal of Business 74(No.

1): 33-57.

These short-term creditors include banks actively participating in

the federal funds market as well as uninsured deposit accounts,

including those with certificates of deposits above the federal

deposit insurance limit.

A few studies find that fully insured deposits provide some mar-

ket discipline.3But these studies are in the minority, with the

vast majority concluding that deposit insurance eliminates depos-

itor incentives to monitor and discipline banks. Deposit insurance

has repeatedly and consistently been shown to be systemati-

cally associated with lower deposit interest rates and increased

bank risk-taking.4And a quite recent study using high-frequency

deposit flow data reports that banks often exploit deposit insur-

ance by raising deposit rates to attract fully-insured deposits to

offset outflows of uninsured deposit balances.5The availability of

a ready supply of insured deposits seems almost certain to relax any

market discipline on bank risk-taking that uninsured depositors

might otherwise provide.

While there was once an academic consensus that uninsured

short-term creditors exert market discipline on banks, much has

changed since most of these studies were published. Some of

the changes in the economic environment have removed the

incentives of some short-term creditors to monitor and discipline

banks. For example, changes in the Federal Reserve’s monetary

policy operating procedures have altered the character of the fed-

eral funds market, a market that historically had provided an

3Davenport, Andrew Mitsunori, and Kathleen Marie McDill. 2006. “The Depositor behind

the Discipline: A Micro-Level Case Study of Hamilton Bank.” Journal of Financial Services

Research 30: 93–109; and Bennett, Rosalind, Vivian Hwa, and Myron Kwast.2015. “Market

Discipline by Bank Creditors During the 2008–2010–crisis.” Journalof Financial Stability 20:

51-69.

4See for example, Demirgüç-Kunt, Asli, and Harry Huizinga. 2004. “Market Discipline and

Deposit Insurance.” Journal of Monetary Economics 51(2): 375-399; Anginer, Deniz, Asli

Demirgüç-Kunt, and Min Zhu. 2014. “How Does Deposit InsuranceAffect Bank Risk? Evi-

dencefromtheRecentCrisis.”Journal of Banking & Finance 48: 312-321; Calomiris, Charles,

and Matthew Jaremiski. 2016. “Stealing Deposits: Deposit Insurance, Risk-Taking and the

Removal of Market Discipline in Early 20th Century Banks,” WorkingPaper Columbia Uni-

versity Graduate School of Business (March 2016). Web site: https://www0.gsb.columbia.

edu/faculty/ccalomiris/papers/Stealing%20Deposits.pdf, or Calomiris, Charles, and Sophia

Chen. 2022. “The spread of deposit insurance and the global rise in bank asset risk since

the 1970s.” Journal of Financial Intermediation 49.

5Martin, Christopher, Manju Puri, and Alexander Ufier. “Deposit Inflows and Outflows in

FailingBanks: The Role of Deposit Insurance,” Working Paper,FDIC 2018-02 (2022). Forth-

coming, Journa l of Financ e, Website: https://www.fdic.gov/analysis/cfr/working-papers/2018/

cfr-wp2018-02-update.pdf

J. Appl. Corp. Finance. 2023;35:7–17. © 2023 Cantillon & Mann.7wileyonlinelibrary.com/journal/jacf