Market Discipline by Depositors: A Summary of the Theoretical and Empirical Arguments

Abstract

Fifty-four banks failed in the first quarter of 1987, more than in any quarter since 1933. Because bank failures are linked to bank risk, most of the regulatory proposals offered to control the growing number of bank failures are designed to encourage depositors to exert market discipline on bank officers and directors, thereby decreasing bank risk and lowering the incidence of bank failure. For policies relying on depositor discipline to be effective, depositors' assets must be exposed to some risk, so that depositors will have an incentive to check the soundness of the banks in which they have deposited their money. At present, however, bank failure policy uses federal bailouts and arranged mergers for most failing banks, providing essentially complete protection for all depositors, regardless of the size of their deposits. This policy reduces the effectiveness of depositor discipline. In addition, the policy removes the incentive for bank managers to limit risk-taking, in effect subsidizing poorly managed, risky banks, and increases the likelihood of bank failures.