The recent wave of financial crises has renewed the interest in market discipline in banking systems. This interest is not merely academic, but it is also apparent in recent policy initiatives such as the latest capital proposal by the Basel Committee on Banking Supervision.
The New Basel Capital Accord put forward by this body has three main components or "pillars." Pillar 3 lays out a number of disclosure requirements that banks are recommended to comply with in order to enhance market discipline. As stated in BIS (2001), "market discipline has the potential to reinforce minimum capital standards (pillar 1) and the supervisory review process (pillar 2), and so promote safety and soundness in banks and financial systems."
Market discipline in banking is commonly understood as a situation in which private sector agents face costs that are positively related to the risks undertaken by banks and react on the basis of these costs (Berger, 1991). This reaction may materialize via prices (such as when depositors demand higher interest) or via quantities (for example, when depositors withdraw funds). Traditionally, the empirical literature has studied market discipline by testing market sensitivity to bank fundamentals, which, if present, has been interpreted as conducive to more prudent risk-taking practices and a healthier banking sector as a whole (hence, the emphasis on information disclosure as a prudential tool).
Both institutional and systemic factors may, however, have important effects on market discipline, at least as it has been traditionally defined. Institutional factors may affect market discipline indirectly, by influencing the degree to which agents react to changes in bank fundamentals. The existence of well-functioning markets, the degree of government ownership of banks, the presence of guarantees, and the level of disclosure and transparency may affect the incentives of and the information available to market participants to respond to banks' idiosyncratic risk.
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Market Discipline in Emerging Economies: Beyond Bank Fundamentals
