Understanding the failures of market discipline.

Author:Min, David
Position:Abstract through III. The Failure of Market Discipline, p. 1421-1468
 
FREE EXCERPT

"Market discipline"--the theory that short-term creditors can efficiently rein in bank risk through their self-interested actions--has been a central pillar of banking regulation since the late 1980s, both in the United States and abroad. While market discipline did not prevent the buildup of bank risk that caused the recent financial crisis, the conventional wisdom has been that this failure was due to extrinsic factors that impeded the effective operation of market discipline, rather than any underlying problems with the theory itself As a result, policymakers have increased regulatory reliance on market discipline, making this a central part of their reform efforts. This Article challenges the prevailing wisdom and makes two contributions to the literature. First, I demonstrate that market discipline failed more severely and completely than has previously been acknowledged. A foundational premise of market discipline is that investors will signal elevated bank risk through higher prices and lower liquidity. But as I illustrate, there was no such reaction until after the financial crisis had already begun, despite historically high levels of bank riskSecond, I attempt to explain why market discipline failed so completely and fundamentally. I contend that the theory of market discipline relies too heavily on investors that are relatively insensitive to risk and thus serve as particularly poor monitors of banks, and wrongly ignores the effects of bank shareholders, who are highly risk-sensitive but may have incentives adverse to those of public policy. Both of these flaws with the doctrine of market discipline arise from its conflation of capital market investors, who generally are quite sensitive to risk, and purchasers of money instruments, who generally are not. Despite these enormous flaws with the underlying doctrine, improving the conditions for market discipline continues to be seen as a panacea for reducing systemic risk, thus increasing the likelihood that regulators may again be blindsided by another financial crisis.

TABLE OF CONTENTS I. INTRODUCTION. II. THE LAW AND ECONOMICS OF MARKET DISCIPLINE A. Federal Deposit Insurance and the Problem of Banking Panics B. Market Discipline as a Critique of Government Guarantees C. The Pre-Crisis Literature on Market Discipline 1. Are Investors Able to Monitor Risky Banks? 2. Does Market Discipline Affect Bank Risk-Taking? 3. Strong Form vs. Weak Form Market Discipline III. The Failure of Market Discipline A. The Implementation of Weak Form Market Discipline B. Shadow Banking and the Reemergence of Strong Form Discipline 1. Limited Government Intervention in Shadow Banking 2. Shadow Banking Investors A re Institutional, Not Retail 3. Delegated Monitors to Ameliorate Information Asymmetry Issues C. The Failure of Markets to Signal Excessive Risk. 1. Liabilities of Individual Banks Failed to Timely Identify Risk 2. Interbank Borrowing Rates Failed to Timely Signal Systemic Risk 3. Market Pricing of ABS Failed to Timely Signal Systemic Risk 4. Clear Evidence of Bank Risk Prior to July 2007 IV. WHY DID MARKET DISCIPLINE FAIL? A. Rejecting the Standard Accounts of Market Discipline's Failure B. Distinguishing Between Investment Securities and Money Instruments C. Market Discipline Relies Heavily on Money Instruments D. Market Discipline Ignores Risk-Sensitive Shareholders E. Procyclicality and Market Discipline F. Reconciling the Empirical Findings V. TOWARDS A NEW MARKET DISCIPLINE. A. Implications for Financial Regulatory Reform 1. Eliminating Expectations of Government Support is Unlikely to Fix Market Discipline 2. Increasing Issuance of Long- Term Debt 3. Improving Transparency B. Delinking the Incentives of Managers and Shareholders C. Reducing Reliance on Market Discipline 1. Increasing Capital Requirements 2. Reducing the Size and Complexity of Financial Institutions VI. CONCLUSION I. INTRODUCTION

The theory of market discipline, which generally asserts that self-interested creditors can provide substantial assistance in reining in the risk-taking of banks, has been a foundational principle of bank prudential regulation since at least the late 1980s. (1) Since that time, this doctrine has become even more important as the principle of market discipline now stands as one of the three so-called "pillars" of banking regulation articulated by the influential Basel Committee, which sets the international standards for prudential regulation of financial firms. (2) Following the financial crisis of 2007-2008, market discipline has been utilized to an even greater extent as a way to augment and improve the regulation of financial intermediaries. (3) As financial institutions have become too large and complex for regulators to understand and oversee on their own, regulators have come to rely heavily on market discipline, both to directly rein in bank risk and to provide them with important pricing signals of which institutions may be seen as higher risk by the markets. (4)

Clearly, market discipline did not succeed in preventing the buildup of bank risk that caused the financial crisis. However, the consensus among most banking regulators and academics is that the failure of market discipline in this regard was due to some structural impediment, such as the presence of implicit guarantees creating moral hazard or informational asymmetries in financial intermediation, which impeded bank creditors from effectively monitoring and influencing bank behavior. (5) In other words, under this view, market discipline did not fail, but rather policymakers and regulators failed in establishing the predicate conditions for market discipline to be successful.

Based in large part on this diagnosis, one of the ways in which policymakers have sought to reform financial regulation has been to call for measures meant to improve the conditions for market discipline, with the goal of increasing its effectiveness. Both Dodd-Frank and Basel III explicitly call for enhanced market discipline, and federal banking regulators have unveiled a number of measures meant to increase reliance on market discipline, as described in greater detail below. (6)

But as this Article demonstrates, this conventional wisdom is wrong, as the doctrine of market discipline failed completely, in a manner inconsistent with these explanations. Investor and market reactions did not, as many advocates of market discipline predicted, prevent the buildup of risk that caused the crisis, a fact that is fairly indisputable. But more troublingly, as this Article demonstrates, the bank (7) creditors and counterparties that were supposed to exert market discipline failed to even respond to heightened bank risk until it was too late.

As Part II of this Article describes, market discipline was supposed to reduce bank risk through two main effects. First, the reactions of interested investors--withdrawing funds and/or demanding higher rates of return from banks taking on greater levels of risk--were themselves supposed to act as a check on the behavior of bank managers, by providing a deterrent (less availability and a higher cost of funds) to taking on greater risk. Second, these market reactions would help to identify risky banks for regulators, who could use these pricing and liquidity signals as a basis for taking early regulatory action against risky institutions, before that risk manifested itself into insolvency. Part II also provides a general overview of the parameters of the doctrine of market discipline, and reviews the precrisis empirical and theoretical literature on market discipline and its effectiveness in reducing bank risk.

A foundational premise of this theory is that creditors can accurately and timely identify risky financial institutions. This should have been especially true for the period preceding the financial crisis, as the conditions were ripe for the success of market discipline, as I discuss in Part III. The explicit adoption of market discipline as a core pillar of traditional banking regulation beginning in the late 1980s facilitated greater transparency from banks and other financial firms, and created new classes of uninsured creditors who were expected to serve as potent new sources of market discipline. At the same time, the rise of "shadow banking"--credit intermediation that took place primarily in the capital markets and thus outside the prudential regulatory framework established for traditional banking--created arguably the optimal conditions for market discipline to succeed. Shadow banking lacks the distortive government guarantees of traditional banking, and moreover has other key aspects that improve conditions for market discipline, such as sophisticated counterparties and the presence of delegated monitors of risk.

But despite the best possible conditions to date for the success of market discipline, this theory failed systemically and completely, as Part III describes in some detail. Every significant market indicator that might have been relied upon by banking regulators utilizing the theory of market discipline--uninsured deposit rates, bank subordinated debt rates, interbank lending rates, credit default swap prices, and many others--failed to provide any indication of elevated levels of risk until after the 2007-2008 crisis had already started, at which point it was too late for regulators to react effectively.

This is problematic, insofar as there was clear, publicly available, and ample evidence of heightened bank risk, both at specific firms and across the broader banking system, as early as 2005. In short, market discipline failed more completely and systematically than has generally been understood, or at least acknowledged.

Part IV shifts to the question of why market discipline failed. It begins by rejecting the standard accounts for this failure, which largely center upon information asymmetry specific to shadow banking, and moral hazard created by...

To continue reading

FREE SIGN UP