Market discipline and regulatory authority oversight of banks: Complements not substitutes

As academic and practitioner research increasingly questions the role and effectiveness of rules-based bank regulatory oversight, in favour of incentive-compatible regulatory design, so the question is raised: what is the appropriate structure for future regulatory design? Through a discussion of the social benefits and costs of introducing incentive-based solutions in bank regulatory design and a review of the empirical evidence, this paper aims to explain why a mixed regulatory approach, consisting of both the regulatory authorities and market-based oversight, and founded on rules and incentives, may be the only solution for efficient and effective regulation. In so doing, the paper confirms the need to create rules that encourage incentive compatible behaviour by all bank stakeholders. It is argued that these rules are compatible with the primary objective of bank regulation, i.e. maintaining systemic stability. With the aid of Hamalainen et al.'s [2004] framework for effective market discipline, the paper also analyses to what extent market-based solutions, in the form of market discipline, can be credibly incorporated into bank regulatory design. As such the paper illustrates how prescriptive rules and the regulatory approach of monitoring that it fosters would still be an essential component of bank regulatory design. Furthermore, this analysis results in a structure for conducting future empirical research on the effectiveness of market discipline.