Bank asset allocation: the effectiveness of market monitoring

Purpose - – The purpose of this paper is to study the effectiveness of market discipline on banks’ risk-taking behavior based on how swiftly banks respond to market information. Design/methodology/approach - – A simplified incentive model provides the necessary justification for two types of market disciplines: first, monitoring by uninsured market participants, and second, risk premium in terms of interest spread required by risk-averse depositors. Panel data regression is carried out for both surviving and failed US banks for the period 1999:Q4-2007:Q3 to examine the role of market discipline, bank capital, and macroeconomic shocks. Findings - – The paper finds that banks which failed during 2007:Q4-2010:Q4 suffered from fundamental weaknesses in their asset quality relative to the surviving banks prior to the crisis. Originality/value - – The paper focusses on two questions: In what circumstance does market monitoring exist? And how can market incentives affect banking firms’ actions? The first question is studied in a simplified incentive model that provides justification for two types of market discipline. Given that, the effectiveness of market discipline is empirically tested, using the US banking data in the period leading up to a surge in the number of bank failures in 2007-2010. The paper's results show that failed institutions with large size were relatively less responsive to early warning signals of declining uninsured deposits and rising deposit spread.