Market Discipline as a Regulator of Bank Risk

The collapse of the savings and loan industry and the failure of large numbers of commercial banks in the 1980s have generated a reexamination of bank regulation in the United States and a new banking act. Despite this increased attention, no consensus about how to reform the banking system has emerged. Instead, proposals range from eliminating deposit insurance and relying solely on market discipline to expanding deposit insurance and relying solely on bank regulators. The banking reformers generally fall into one of two groups. The first believes the best way to correct the problem of banks taking on too much risk is to provide regulators with the right tools. Most in this group question the use of market discipline because they have little confidence that depositors can adequately monitor banks and they are concerned that runs on individual banks could easily turn into systemwide banking panics. The second group believes that market discipline is the best way to regulate banks. These reformers argue that market forces are far better than regulators at assessing and pricing bank risk and that the benefits of market discipline outweigh the costs associated with bank runs and banking panics. The evidence, in my view, supports those in the pro-market group, although it does not support unfettered competition. On the one hand, history suggests that banking can be a very unstable industry and that this instability has had far-reaching effects on the rest of the economy.