Market discipline in bank regulation: panacea or paradox?

• Author: Maclachlan, Fiona C.

Central bankers speak of three pillars supporting the achievement of their objectives: regulation, supervision, and market discipline. Recently, the third pillar--market discipline--has received greater attention as the increasing size and complexity of financial services firms has placed strain on the other two pillars, raising concerns about systemic risk. The Basel Committee on Banking Supervision (2001) makes reference to the three-pillar approach in its recent proposal for a New Basel Capital Accord. In the proposal, the recommendations regarding market discipline relate mainly to greater public disclosure of each bank's condition. Central bankers at the Federal Reserve System, including Governor Laurence H. Meyer (1999) and Minneapolis Federal Reserve Bank president Gary Stern (1999), advocate a more specific policy mandating that large banks issue subordinated-debt securities. Subordinated debt (subdebt) is a bank liability representing borrowing that, in the event of default, would be paid only after all other liabilities had been discharged. Aware of the potential for significant loss, investors in subdebt are especially sensitive to the risk of default, and their perception of increases in that risk will be reflected in lower market valuations and hence higher yields for subdebt. Policy involving mandatory subordinated debt employs such a change in market valuation as a signal for regulator response. Because it is the market that sends the signal, this policy is associated with the market discipline pillar of the central bankers' triad. The 1999 Gramm-Leach-Bliley Act called for the Federal Reserve Board and the secretary of the Treasury to study the feasibility and desirability of subdebt proposals. The study, released in January 2001, concluded that adoption of a subordinated-debt policy potentially might improve the safety and soundness of the banking system, but recommended that more evidence be gathered before legislators embed subdebt policy in the law.

The idea of market discipline operating in a highly regulated and protected industry seems somewhat paradoxical. Bankers and their stakeholders factor the existence of a safety net into their decision making. One wonders how market discipline can exert much pressure in the safety-net environment. I explore that general question here by examining specific subdebt proposals. I find that only the proposals that rely on a strict rule employ something approaching market discipline. Proposals that involve regulatory discretion actually pertain more to the other two pillars of the banking support triad--supervision and regulation. In addition, we have strong reasons to expect that if a subdebt policy were adopted, it would involve regulator discretion.

The Case for Market Discipline

The safety net that banks and their stakeholders have come to expect includes deposit insurance and a lender of last resort. Stanley Fischer (1999) notes that lenders of last resort play two roles: one as crisis lender, another as crisis manager. In the latter role, the lender of last resort brings together private lenders to help a troubled institution. C. Goodhart and D. Schoenmaker (1995) conclude from their study of modern banking crises that organizing concerted lending is the most common bailout procedure for lenders of last resort.

The moral hazard problems associated with the safety net are widely recognized (Short and Robinson 1998). In relation to deposit insurance, the problem is that depositors no longer discipline the banks by refusing to place their money in risky institutions. The lender of last resort further insulates banks from the downside consequences of risky activities. The traditional approach to dealing with moral hazard involves a combination of supervision, regulation of bank activities, and capital standards. Each component poses problems.

Regulations are static, but the financial environment is dynamic. For example, regulations put in place at the time deposit insurance was adopted in the United States in the 1930s created serious problems for banks when economic conditions changed and interest rates rose to unprecedented levels in the 1970s and 1980s. Regulations restricting the range of assets prevented banks from taking advantage of the principle of diversification. Savings and loan (S&L) institutions, in particular, ran into trouble because their lack of diversification led to substantial interest-rate risk exposure. Interest-rate ceilings gave rise to disintermediation as depositors pulled their money out of banks in search of market rates of return.

Supervisors may not have incentives to do an adequate job--the same principal-agent problem that arises whenever government agents are given the responsibility of acting in the public interest. Typically, supervisors do not bear the cost when they do a poor...