Last week, James Kwak (UConn law professor, co-author of 13 Bankers and White House Burning, and blogger at the Baseline Scenario) provided a nice writeup of some of the key issues I identify in my paper, Understanding the Failures of Market Discipline, recently posted to SSRN. But I wanted to take a few words to provide a slightly more detailed explanation of my work.
“Market discipline”—the notion that short-term creditors (such as bank depositors) can efficiently identify and rein in bank risk—has been a central pillar of banking regulation since the 1980s. Obviously, market discipline did not prevent the buildup of bank risk that caused the recent financial crisis, but the general consensus has been that this failure was due to structural impediments to the effective operation of market discipline—such as misaligned incentives, a lack of transparency, or moral hazard caused by implicit guarantees—rather than any problems with the concept itself. As a result, a major point of emphasis in financial regulatory reform efforts has been to improve and strengthen market discipline.