Market discipline

Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy. This means, in order to meet economic necessity, buyers must avoid prices that will drive them into bankruptcy and sellers must find prices that will generate revenue (or suffer the same fate).

Market discipline is a topic of particular concern because of banking deposit insurance laws. Most governments offer deposit insurance for people making deposits with banks. Normally, bank managers have strong incentives to avoid risky loans and other investments. However, mandated deposit insurance eliminates much of the risk to bankers. This constitutes a loss of market discipline. In order to counteract this loss of market discipline, governments introduce regulations aimed at preventing bank managers from taking excessive risk. Today market discipline is introduced into the Basel II Capital Accord as a pillar of prudential banking regulation.

The efficacy of regulations aimed at introducing market discipline is questionable. Financial bailouts provide implicit insurance schemes like too-big-to-fail, where regulators in central agencies feel obliged to rescue a troubled bank for fear of financial contagion. It can be argued that depositors would not bother to monitor bank activities under these favorable circumstances. There are numerous academic studies on this subject. The findings, at first, had mixed and somewhat discouraging results where market discipline did not appear to be an essential feature in banking. Later studies, though, when including some of the previously missing key aspects into the empirical analysis, supported the existence and significance of such a natural control mechanism unambiguously. Accordingly, depositors 'discipline' bank activities to some extent depending on the well functioning of financial markets and institutions.

Since 1990's there is an increase of interest among policymakers and academics for enhancing the environment for market discipline. The reason being: Financial engineering and technological improvements enabled financial intermediaries to be involved in overly complex and advanced financial operations. These activities become more and more costly to monitor and supervise from the regulatory agency perspective. This is precisely why regulators support the idea of including market discipline as another channel to complement regulatory policies. In a study reported to the Congress in 1983 by the FDIC, the challenge to the possibility of restructuring financial markets is stressed quite nicely:

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