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Bank Moral Hazard and Market Discipline

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  • Elena Carletti
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    Abstract

    We show that market discipline can be effective in resolving the moral hazard problem which arises when depositors do not know whether bankers are monitoring or not the projects they finance. Demandable debt, by allowing the possibility of bank runs, can induce bankers to monitor. However, market discipline comes at a cost. When depositors are not equally informed about the future value of bank assets, withdrawals caused by a liquidity shock may be confused with future insolvency and cause uninformed depositors to precipitate a run. Likewise, withdrawals due to upcoming insolvency may be confused with a liquidity shock and dissuade depositors from running. Bank runs are, therefore, costly and imperfect disciplinary devices for bankers. Our results offer a new perspective on the debate on market versus regulatory discipline of banks.

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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp326.pdf
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    Bibliographic Info

    Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp326.

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    Date of creation: May 1999
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    Handle: RePEc:fmg:fmgdps:dp326

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    Web page: http://www.lse.ac.uk/fmg/

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    Cited by:
    1. Carletti, Elena & Hartmann, Philipp, 2002. "Competition and stability: what's special about banking?," Working Paper Series 0146, European Central Bank.
    2. Rochet, Jean-Charles & Vives, Xavier, 2004. "Coordination Failures and the Lender of Last Resort : Was Bagehot Right After All?," IDEI Working Papers 294, Institut d'Économie Industrielle (IDEI), Toulouse.
    3. Jean-Charles Rochet, 2004. "Rebalancing the three pillars of Basel II," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Sep, pages 7-21.
    4. Jean-Charles Rochet, 2003. "Réglementation prudentielle et discipline de marché," Revue d'Économie Financière, Programme National Persée, Programme National Persée, vol. 73(4), pages 201-212.
    5. Décamps, Jean-Paul & Rochet, Jean-Charles & Roger, Benoît, 2003. "The Three Pillars of Basel II, Optimizing the Mix," IDEI Working Papers 179, Institut d'Économie Industrielle (IDEI), Toulouse.
    6. Georges Dionne, 2003. "The Foundationsof Banks' Risk Regulation: A Review of Literature," THEMA Working Papers 2003-46, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
    7. Rochet, Jean-Charles, 2003. "Rebalancing the 3 Pillars of Basel 2," IDEI Working Papers 224, Institut d'Économie Industrielle (IDEI), Toulouse.

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