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Understanding the Failures of Market Discipline

Publication Title

Washington University Law Review

Abstract

“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 risk. Second, 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.

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