Market discipline, disclosure and moral hazard in banking

This paper examines empirically the hypothesis that market discipline is effective in providing incentives for banks to limit their risk of default, by holding capital buffers against adverse outcomes in portfolio risk. We have constructed a large cross-country panel data set consisting of observations on 729 individual banks from 32 different countries over the years 1993 to 2000. Theory implies that the strength of market discipline ought to be related to the extent of the government safety net, the observability of bank risk choices and to the proportion of uninsured liabilities in the bank's balance sheet. Using panel data techniques, we test whether these factors provide incentives for banks to hold larger capital buffers against adverse outcomes in portfolio risk. Our results suggest that government safety nets result in lower capital buffers and that stronger market discipline resulting from uninsured liabilities and disclosure results in larger capital buffers, all else equal. While our results therefore point to the effectiveness of market discipline mechanisms in general, we also find that the effect of disclosure and uninsured funding is reduced when banks enjoy a high degree of government support. Our results finally suggest that while competition leads to greater risk taking incentives, market discipline is more effective in curbing these incentives in countries where competition among banks is strong. (c) 2006 Elsevier Inc. All rights reserved.