Market discipline

Question 1

What are the several problem that traditional bank regulation faces ?

Answer 1

• Monitoring by authorities may crowd out monitoring efforts by private investors
• Regulation may be rendered ineffective by regulatory capture, forbearance, and biased objectives
• Increasing complexity of large banks makes difficult to monitor with traditional supervisory tools

Question 2

On what relies indirect market discipline?

Answer 2

On idea that monitoring by market participants may generate signals useful for supervisors

Question 3

What are the signals from indirect market discipline?

Answer 3

• Represent new information to supervisors
• Information already known by supervisors
• May trigger mandated supervisory responses

→ Improve quality of supervisors’ assessment/forecast about bank’s condition
→ Mitigate problems caused by regulatory capture, forbearance, and biased objectives

Question 4

What are tow characteristics of subordinated debt that makes it appealing as regulatory tool?

Answer 4

• Subordinated debt not protected by deposit insurance and junior to other forms of debt
o Investors have incentive to monitor bank’s risk

• Contrast to equity, subordinated debt exhibits concave return profile
o Investors = negatively affected by bank’s risk taking
o Interest rates rise if bank takes more risk

Question 5

Can indirect market discipline be effective?

Answer 5

Incentives to monitor and mkt prices = endogenous could compromise indirect mkt discipline’s effectiveness.
If monitoring = costly and investors know bank is forced to reduce risk once yield spreads exceed cap, incentives to monitor may be destroyed

Question 6

On what assumption is the direct market discipline based?

Answer 6

Market participants not only monitor banks but influence their behavior.

Question 7

How do market participants discipline banks’ behavior?

Answer 7

• Quantities (e.g. volume of deposits)
• Prices (e.g. share prices or interest rates

→ Banks face consequences of changing quantities and prices = should discipline banks’ behavior

Question 8

How do Calomaris and Kahn contrast with DD?

Answer 8

Demand deposits not used to insure depositors against random liquidity shocks but demandable debt serves as part of incentive scheme for disciplining banks.
→ If misbehave: depositors withdraw and start bank run
→ By submitting to the threat of liquidation, bank may in turn be able to reduce its funding costs

Question 9

Why is the possibility of bank runs crucial?

Answer 9

• Disciplining banks

* Giving depositors incentive to monitor

Question 10

What are the banks’ features in the CK model?

Answer 10

• Enjoy informational advantage in determining which projects are most worthy of financing
• Ability to act against depositors’ interests by absconding with their funds

→ For given stipulated repayment, banker’s incentive to abscond = high if project’s return = low

Question 11

What are the depositors’ features in the CK model?

Answer 11

• If monitor bank, receive either good or bad signal about project’s success
• Monitoring costly

Question 12

What are CK main results ?

Answer 12

Demandable debt gives depositors ability to force unsuccessful or noncomplying banks into liquidation

• If monitoring costs not too high, banks can commit to repayments which would otherwise not be possible
• Depositors have incentive to monitor banks

Question 13

What are the crucial assumptions of CK?

Answer 13

• Bank runs and forced liquidation are feasible
o Neglects negative externalities and costs of bank failures
o Costs of this type of mkt discipline extremely high

• Depositors can monitor banks’ behaviour at low costs
o Costs may be prohibitively high because of banks’ opaqueness
o May be ineffective

Question 14

What is price based market discipline?

Answer 14

Mkt discipline based on mkt prices where funding costs increase in risk taking.

Question 15

What if the banks cannot credibly commit on given level of risk at time subordinated debt’s interest rate is set?

Answer 15

• Limited liability incentivizes banks to take higher risks
• Investors anticipate banks’ increased risk taking and demand higher interest rates in turn
• Higher interest rates lead to more risk taking

→ Observation that riskier banks face higher funding costs not evidence of effective mkt discipline
→ Price based mkt discipline can lead to even higher risk than subsidized deposit insurance

Question 16

What is Blum’s Model structure?

Answer 16

• Single, risk neutral bank investing available funds in risky project choosing level of risk X
• Level of risk observable but not verifiable
• Bank funded by demand deposits with interest rate r_D
• Risk free rate rf
• Bankruptcy has social costs C_S and private costs C_B

Question 17

What are the 2 results from Blum?

Answer 17

Result 1:
• If bank able to commit to level of risk, mkt discipline leads to lower level of risk than subsidized deposit insurance
o Funding costs = risk dependent
o Mkt discipline cannot remove bank’s inventive to take excessive risks due to externalities C_S

Result 2
• If bank cannot commit and if nash equilibrium, mkt discipline implies higher level of risk than subsidized deposit insurance
o Higher funding costs, limited liability gives incentive to increase risks
o Increasing risks lead to higher funding costs as depositors need to be compensated for increasing risk of default

→ Funding costs reflect banks risk
→ Raising funding costs do not discipline bank, opposite is the case