by Katerina Simons and Stephen Cross
May/June 1991

In the present climate of intense debate over deposit insurance reform, the nature and limits of market discipline become especially important. The widely accepted argument for greater reliance on market discipline is that it will restrain managerial risk-taking and reduce potential losses to the deposit insurance fund. Opponents of this view favor the traditional reliance on supervision by the bank regulatory agencies as the primary method to maintain the safety and soundness of the banking system and the integrity of the deposit insurance fund.

This article attempts to shed some empirical light on the issue by studying the effectiveness of market discipline as it is exercised by bank stockholders. Residual analysis is used to test whether the market anticipates the bank’s downgrade to a problem bank status. The results show that shareholder returns fail to anticipate bank downgrades by examiners. These results cast serious doubt on the supposed advantages investors, and particularly uninsured depositors, would have over bank regulators in restraining risk-taking by banks and in monitoring their management.

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