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

Abstract

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.

Notes

1. As the current Chairman of the Basel Committee has stated, ‘the 1988 Accord was a blunt instrument that quickly fell behind the times’ [Caruana, 2003]. This exposes a natural weakness of mechanical formulas: they typically have to be adjusted when there are changes in the environment [Estrella, 1998].

2. Calomiris's [1993] work explains how US regulatory authorities have historically placed a great deal of focus on bank regulatory structures. He argues that policymakers misguided influence of events of the Great Depression and the inherent instability of banking has consistently encouraged reactionary government intervention, not realising ‘that the fragility of American Banking has always been an artefact of a fragmented, inefficient and uncoordinated banking system’. The volatile financial environment of the 1970s and 1980s provided a rigorous test for the US interventionist regulatory structure. Congress responded by passing further legislation, which although steps in the right direction, continued the ‘knee-jerk’ reactionary approach.

3. They are the Banking Acts of 1979 and 1987; the Financial Services Act 1986; the Building Societies Act 1986; and the Financial Markets and Services Act 2000.

4. As Caruana [2003] states, ‘Rules … offers the greatest clarity to institutions on what supervisors expect from banks’.

5. Benink and Wihlborg [2002] argue how regulatory capital arbitrage may remain under the currently proposed New Basel Capital Adequacy Framework. Again, this stems from the nature of rules-based regulations and the regulated institutions instincts for ‘gaming and manipulation’ of proposed regulations. Equally, it highlights that formulas have difficulty in accurately identifying appropriate levels of regulatory capital.

6. This discussion emphasises that rules can be devised and incorporated into regulatory design in many guises. Black [1994] discusses how rules can differ based on three dimensions. Llewellyn [2000b] expands on this to discuss the trade-off between precision, ease of enforcement and the degree of flexibility within the regulatory regime. Furthermore, he discusses how the degree of precision within rules may have a positive or negative impact on compliance culture. The preceding discussion on the government interventionist era of regulation illustrates the negative impact of excessive precision.

7. The UK Financial Services Act 1986 and its creation of numerous Self-Regulatory Organisations (SROs) with their own rule books, led to accusations of excessive regulatory duplication and poor reporting channels between the numerous regulators.

8. See Kaufman [1997] for a discussion on the use of prompt corrective action measures in the US.

9. This is an example of indirect market discipline. Complementing this are direct market discipline and semi-direct market discipline. See section three for further details.

10. As Mayes [2000] states, in the context of the market discipline regulatory design that was implemented in New Zealand, ‘the principal feature of the new system is that it puts the responsibility for the prudent management of banks firmly on the directors and management of the banks themselves’.

11. Institutional investors are at their most powerful when the onus is on company management to negotiate with them for new funds [Short and Keasey, 1997]. A mandatory subordinated debt policy would necessitate regular calls on the debt market for funds, providing debt investors with a significant governance mechanism that is, by its nature, infrequently applied by providers of equity finance.

12. Additionally, different classes of private bank stakeholder do not have the same informational needs as a result of their different risk/return profiles.

13. The terms direct and indirect market discipline are frequently referred to in the literature, but there is a distinct lack of agreement over their meaning and scope. This in turn has implications for the creation of, and subsequent conclusions derived from, empirical market discipline studies. This section aims to set out a structured approach for using these concepts in the market discipline context.

14. Some mandatory subordinated debt proposals incorporate similar semi-direct style incentives, such as puttable subordinated debt [Wall, 1989].

15. The definitions of direct, semi-direct and indirect set out in this paper would categorise the effectiveness of market discipline research by Bliss and Flannery [2001] as a study of semi-direct market discipline through distant action measures (i.e. changes in secondary market prices).

16. As the US Shadow Financial Regulatory Committee [2000] suggests, the prompt corrective action measures of the FDICIA have ‘helped to restore a measure of market discipline to banking in the United States, by making it more difficult to bail out uninsured depositors and by instituting specific requirements for enforcing violations of bank capital requirements’. Aggarwal and Jacques [2000], provide empirical evidence that ‘prompt corrective action has had a significant impact both in terms of raising capital ratios and reducing credit risk for banks’.

17. This is especially likely as the market includes the institutions that are being regulated, the banks, which are unlikely to demand more public scrutiny of their own operations. In fact, past experiences illustrate that UK banks have not been particularly forthcoming in enhancing bank transparency. In response to the Cruickshank report ‘Competition in UK Banking’, the FSA [2000b] made it clear that banks had not voluntarily done enough to provide sufficient information to the market. Furthermore, the FSA [2000a] examined the extent of current disclosures by UK banks and noted that: ‘In general banks do not go beyond U.K. GAAP and, where applicable, SEC disclosure requirements’, thus emphasising the structural importance that the regulatory authorities have to create a more stringent disclosure regime for banks to adhere to.