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Best Instruments for Market Discipline in Banking


  • Greg Caldwell


The author develops a dynamic model of banking competition to determine which capital instrument is most effective in disciplining banks' risk choice. Comparisons are conducted between equity, subordinated debentures (SD), and uninsured deposits (UD) as funding sources. The model, adapted from Repullo (2004), analyzes the effectiveness of regulatory capital when banks incorporate charter value and competition for depositors into their risk-taking decision. The paper's main finding is that although all three instruments can induce market discipline on banks, equity weakly dominates SD and UD (with SD weakly dominating UD).

Suggested Citation

  • Greg Caldwell, 2007. "Best Instruments for Market Discipline in Banking," Staff Working Papers 07-9, Bank of Canada.
  • Handle: RePEc:bca:bocawp:07-9

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    References listed on IDEAS

    1. Robert R. Bliss, 2001. "Market discipline and subordinated debt: a review of some salient issues," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 24-45.
    2. John Krainer & Jose A. Lopez, 2008. "Using Securities Market Information for Bank Supervisory Monitoring," International Journal of Central Banking, International Journal of Central Banking, vol. 4(1), pages 125-164, March.
    3. Calomiris, Charles W., 1999. "Building an incentive-compatible safety net," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1499-1519, October.
    4. Berger, Allen N. & Herring, Richard J. & Szego, Giorgio P., 1995. "The role of capital in financial institutions," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 393-430, June.
    5. anonymous, 1999. "Using subordinated debt as an instrument of market discipline," Staff Studies 172, Board of Governors of the Federal Reserve System (U.S.).
    6. Jones, David, 2000. "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 35-58, January.
    7. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    8. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
    9. Robert DeYoung & Tara Rice, 2004. "How do banks make money? the fallacies of fee income," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q IV, pages 34-51.
    10. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    11. Flannery, Mark J & Sorescu, Sorin M, 1996. " Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983-1991," Journal of Finance, American Finance Association, vol. 51(4), pages 1347-1377, September.
    12. Black, Fischer & Cox, John C, 1976. "Valuing Corporate Securities: Some Effects of Bond Indenture Provisions," Journal of Finance, American Finance Association, vol. 31(2), pages 351-367, May.
    13. Julapa Jagtiani & Catharine Lemieux, 1999. "Stumbling blocks to increasing market discipline in the banking sector: a note on bond pricing and funding strategy prior to failure," Emerging Issues, Federal Reserve Bank of Chicago, issue Sep.
    14. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt and bank capital reform," FRB Atlanta Working Paper 2000-24, Federal Reserve Bank of Atlanta.
    15. Mark Flannery, 2001. "The Faces of “Market Discipline”," Journal of Financial Services Research, Springer;Western Finance Association, vol. 20(2), pages 107-119, October.
    16. Greg Caldwell, 2005. "Subordinated Debt and Market Discipline in Canada," Staff Working Papers 05-40, Bank of Canada.
    17. Marc J. K. De Ceuster & Nancy Masschelein, 2003. "Regulating Banks through Market Discipline: A Survey of the Issues," Journal of Economic Surveys, Wiley Blackwell, vol. 17(5), pages 749-766, December.
    18. Herring, Richard J., 2004. "The subordinated debt alternative to Basel II," Journal of Financial Stability, Elsevier, vol. 1(2), pages 137-155, December.
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    Cited by:

    1. Zhang, Zhichao & Song, Wei & Sun, Xin & Shi, Nan, 2014. "Subordinated debt as instrument of market discipline: Risk sensitivity of sub-debt yield spreads in UK banking," Journal of Economics and Business, Elsevier, vol. 73(C), pages 1-21.

    More about this item


    Financial institutions;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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