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Depositor discipline at failing banks

  • John S. Jordan
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    Uninsured depositors, whose deposits are not fully protected by federal deposit insurance, have an incentive to monitor banks' activities and impose additional funding costs on risky banks. This pricing is a form of market discipline, since the market penalizes banks for taking on greater risk. For banks that become troubled, market discipline can take a more severe form: Market participants may become unwilling to supply uninsured funds at any reasonable price. This study examines the effectiveness of depositor discipline at banks that failed in New England in the early 1990s. ; The empirical analysis examines whether failing banks in New England faced depositor discipline as they became troubled in the early 1990s, and whether these banks attempted to shield themselves from this discipline. Failing banks in New England experienced a 70 percent decline in their uninsured deposits in their final two years of operation. The author finds that despite the magnitude of the gap to fill, and despite the presence of close regulatory scrutiny, many failing banks increased their use of insured deposits enough to offset much of the shortfall created by the decline in uninsured deposits, diminishing the effectiveness of market discipline by depositors.

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    File URL: http://www.bostonfed.org/economic/neer/neer2000/neer200b.htm
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    File URL: http://www.bostonfed.org/economic/neer/neer2000/neer200b.pdf
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    Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

    Volume (Year): (2000)
    Issue (Month): Mar ()
    Pages: 15-28

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    Handle: RePEc:fip:fedbne:y:2000:i:mar:p:15-28
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    1. Timothy H. Hannan & Gerald A. Hanweck, 1986. "Bank insolvency risk and the market for large certificates of deposit," Working Papers in Banking, Finance and Microeconomics 86-1, Board of Governors of the Federal Reserve System (U.S.).
    2. Herbert Baer & Elijah Brewer, 1986. "Uninsured deposits as a source of market discipline: some new evidence," Economic Perspectives, Federal Reserve Bank of Chicago, issue Sep, pages 23-31.
    3. Joe Peek & Eric Rosengren, 1991. "The capital crunch: neither a borrower nor a lender be," Working Papers 91-4, Federal Reserve Bank of Boston.
    4. George J. Benston & George G. Kaufman, 1997. "FDICIA after Five Years," Journal of Economic Perspectives, American Economic Association, vol. 11(3), pages 139-158, Summer.
    5. John Jordan & Jane Katz, 1999. "Banking in the age of information technology," Regional Review, Federal Reserve Bank of Boston, issue Q4, pages 24-30.
    6. Flannery, Mark J, 1982. "Retail Bank Deposits as Quasi-Fixed Factors of Production," American Economic Review, American Economic Association, vol. 72(3), pages 527-36, June.
    7. Ellis, David M. & Flannery, Mark J., 1992. "Does the debt market assess large banks, risk? : Time series evidence from money center CDs," Journal of Monetary Economics, Elsevier, vol. 30(3), pages 481-502, December.
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