Understanding the failures of market discipline.

• Author: Min, David
• Position: IV. Why Did Market Discipline Fail? through VI. Conclusion, with footnotes, p. 1468-1501

4. WHY DID MARKET DISCIPLINE FAIL?

   In hindsight, it is clear that bank investors did not actually rein in the risk taken by banks and other financial institutions as strong form market discipline would have predicted. More surprisingly, and in contradiction to the central assumptions of weak form market discipline, markets did not provide any signals of elevated risk, either with respect to individual firms or on a systemic level. Indeed, it was only after a mass downgrade of credit ratings on major shadow banking liabilities that market discipline began to exert itself as theory would have predicted. So the question we are faced with, and which this Part attempts to answer, is: Why did market discipline experience such a broad and complete failure in the period immediately preceding the 2007-2008 financial crisis?

   Conventional wisdom argues that market discipline failed because some necessary condition precedent, such as sufficiently detailed disclosures or insufficient incentives for investors, was lacking. As I describe below, these lines of argument fail to acknowledge or explain the particular ways in which market discipline failed. Under these explanations, market discipline should have been dampened, but not nonexistent, not only in the period preceding the financial crisis, but also during and after the financial crisis. Yet what we saw in the period up until July 2007 was a complete absence of any signals of heightened risk from likely sources of market discipline, as described in Part II. This argument also fails to explain why market reactions became so suddenly and violently sensitive to risk-related information following the ratings downgrades of July 2007.

   Instead, this Article argues that the failures of market discipline are attributable to its conflation of two highly distinct types of financial instruments--those that serve as a form of investment ("investment securities"), and those that serve as a form of money ("money instruments"). Like other types of firms, banks issue investment securities, such as equity shares or bonds, which are meant for investment purposes. The purchasers of these types of securities closely monitor and react to risk, in accordance with the efficient markets hypothesis, as described previously. But hanks are unique in that they also issue money instruments, such as demand deposits, that serve as a transactional medium.

   The theory of market discipline generally assumes that these money instruments are also risk-sensitive securities, insofar as the purchasers of these money instruments monitor and promptly react to new risk-related information. But there are strong economic reasons to question this assumption. As economist Gary Gorton and others have argued, because money instruments are primarily acquired and held as a transactional medium, they are most efficient when they are informationally insensitive, meaning when they are not reacting in price or liquidity to new information about bank risk. (202) While constant risk-based adjustments to pricing may be efficient from the perspective of capital investors, this is not necessarily the case for those seeking to use monetary instruments to conduct commercial transactions. For these investors, such constant fluctuations in pricing (and the costs and efforts of diligence entailed in monitoring the correct risk-adjusted price) are economically inefficient.

   The confusion between money instruments and investment securities has led to two critical flaws in the theory of market discipline. First, this doctrine tends to rely heavily on the market actions of investors in money instruments (such as depositors), but these investors are generally insensitive to new risk-related information and thus would serve as particularly poor monitors. Second, market discipline largely ignores the monitoring and disciplining conducted by shareholders (and similarly situated investors), who are arguably the most important and diligent type of bank investor, but who may have incentives adverse to those of banking regulators. Indeed, in the aftermath of the 2007-2008 financial crisis, a number of studies have made clear that shareholder pressure played a key role in banks' decisions to take on greater risk, as I describe in this Part.

   Collectively, these two critiques of the theory of market discipline suggest a broader problem--namely, that market discipline may have the effect of exacerbating bank procyclicality, encouraging banks to take on too much risk during growth periods and too little risk during downturns. To the extent that money market investors may be informationally insensitive during most parts of the economic cycle, they should not be expected to provide effective and consistent market discipline. On the other hand, the market discipline exerted by shareholders and similarly situated investors, who are quite sensitive to risk-related information at all times, is likely to encourage greater risk-taking, particularly during expansionary periods. During credit contractions, both creditors and shareholders are likely to be excessively risk-averse, encouraging banks to shed more risk than is socially optimal. Thus, efforts to increase market discipline may lead to greater procyclicality and, perversely, may lead to more bank risk-taking during credit expansions.

   This Part proceeds in five sections. First, it recounts and rejects the standard explanations for the failures of market discipline during the pre-crisis period. Second, it points out that the bank investors relied upon to provide market discipline are a heterogeneous group, as holders of money instruments are situated quite differently than other types of investors. Third, this Part argues that the heavy reliance of market discipline on investors in money instruments is flawed, insofar as these investors are generally informationally insensitive to risk. Fourth, I describe how market discipline tends to ignore the effects of bank shareholders, as these investors are seen as having interests that are misaligned with those of regulators, and argue that this is a critical oversight. Finally, I show that these explanations, currently overlooked in the literature on market discipline, help to explain and resolve the empirical findings, both pre-crisis and post-crisis, around market discipline, and discuss the potential problem of procyclicality that may result from efforts to increase market discipline.

   1. Rejecting the Standard Accounts of Market Discipline's Failure

      The typical explanation for the pre-crisis failures of market discipline has been that market discipline was dampened due to structural problems in shadow banking and securitization, which prevented market forces from reaching efficient outcomes. Among the problems that have been identified are misaligned incentives (particularly for the credit rating agencies), (204) a lack of sufficiently detailed or clear information, (205) and moral hazard that eroded the incentives for investors to monitor banks, either emanating from the existence of implicit guarantees (206) or from the bankruptcy code's strong protections for the collateral held by CDS and repo counterparties. (207)

      But these explanations for the failures of market discipline do not well describe the actual performance of market discipline before and during the financial crisis. It is indisputable that there were agency and information problems in shadow banking and asset securitization, and it seems likely that these detracted from the perfect operation of market discipline. It is also fair to point out that moral hazard may have suppressed the incentives for investors to monitor banks, particularly those that were seen as enjoying implicit government guarantees by virtue of being "too big to fail." But even if we assume that these conditions served as significant barriers to effective market discipline, this does not explain the particular market reactions we observed during the period in the years before and after the onset of the financial crisis--longstanding and complete investor complacency, followed by a sudden and violent spate of activity beginning in July 2007.

      Of course, one important rebuttal to the argument that imperfect information was primarily to blame for the lack of market discipline was that plenty of good information about the riskiness of financial firms was publicly available. As one proponent of this argument acknowledges:

      [O]ne of the more difficult aspects of the Financial Crisis was that the very institutions whose subprime exposures were so opaque were the same institutions producing enormous quantities of mandatory disclosures. For publicly traded firms such as Citigroup, these disclosures included the periodic reporting obligations imposed by the Securities Exchange Act of 1934, as well as quarterly and annual banking reports required to be filed by all banks and bank-holding companies. Additionally, international banks, subject to the Basel Accord, were required to make quarterly and annual public disclosures pursuant to the Accord's "Pillar 3" Market Discipline provisions. (208) But even if we ignore this fact and accept the argument that informational asymmetries were significantly muting market discipline, it is difficult to reconcile this argument with what happened in the period preceding the financial crisis. After all, by 2006, home prices had begun to decline and the rate of delinquencies for subprime mortgages had begun to spike, doubling over the previous year. (209) These indicia of risk were publicly available to investors, and it is certain that these were sufficiently abundant and clear in indicating that bank risk was rising, both systemically and at certain firms that had taken on uniquely high exposure to U.S. mortgages. And yet the pricing signals relied upon by market discipline did not react in any way until July 2007, as described in Part II.

      The moral hazard argument also fails to...