Invisible hand discipline from informed trading: Does market discipline from trading affect bank capital structure?

A bank generally hold more equity capital than required by their regulators. We hypothesize that stock market has a disciplining role vis-à-vis bank managers that forces them to increase their capital level. For market discipline to be effective, market factors such as changes in firm equity values and returns, would influence bank decision making. We apply the model to annual panel data for publicly traded bank holding companies in three stock markets over a sample period from 2006 to 2015. Using OLS and fixed effect, we find a significantly positive relationship between market discipline and bank capital structure. In addition, we find that market discipline is a more effective to enhance bank capital when bank perform efficiently. Robust tests based on instrumental variable and dynamic GMM evidence of a causal link between market discipline and bank capital structure. The results have certain policy implications for understanding the role of stock market in affecting bank operation that in turn could improve bank prudency and assist the design of an enhanced regulation framework.