Abstract:The recent financial crisis highlights the importance of both regulatory and market discipline. Government reactions to the crisis include expanding deposit insurance coverage and rescuing troubled institutions, including some that might not otherwise be considered too big to fail, which may have the unintended consequence of a reduction in depositor discipline that might otherwise penalize banks for risk-taking behavior. To examine the potential for this to occur, we test for the presence of depositor discipline effects in the period leading up to the financial crisis in both the US and the EU. We find significant depositor discipline in both the US and EU, but this varies between the US and the EU, and also varies with banking organization size and with listed versus unlisted status. We also find that depositors appear to react more consistently to equity ratios than measures of loan portfolio performance, the latter of which may sometimes considered too manipulable to be trusted. This is consistent also with the requirements of Basel III that increase the minimum amount of Tier 1 common equity.
Keywords:Market Discipline, Depositor Discipline, Banks
JEL classifications: G21, G28