Market Discipline in Regulation: Pre- and Post-Crisis

With the introduction of Basel II in 2004, “market discipline” became one of the Basel Committee’s three pillars of prudential regulation. Although many academic papers have sought to test for the presence of effective market discipline in banking, few have dealt fully with the question. Effective market discipline involves two distinct steps: monitoring a bank’s condition and influencing it to avoid unacceptably large risks. Both phases of market discipline are necessary; neither alone is sufficient. In this chapter, we provide a careful definition of market discipline, explain how it may complement supervisory efforts to control an institution’s risk-taking, and review the available literature on the efficacy of market discipline. We also discuss how recent changes in supervisory actions toward failing banks has changed the channels through which market discipline will work going forward.