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Is market discipline dead? Market discipline as a means to check the systemic risk posed by financial institutions was very much in vogue in financial institution scholarship until the financial crisis. Not any more. There are certainly calls for restraining government bailouts and some interesting work on contingent convertible capital requirements. But, by and large, this pillar seems to have been moved to the back of the financial regulation temple.

Kate Judge (Columbia) has a new paper (forthcoming in the UCLA Law Review) that cuts against this contemporary conventional wisdom. She argues for revisiting and rethinking the idea of interbank discipline ? that is the incentives and capacities of large, complex banks to monitor and check the risk-taking of their counterparties. Here is her abstract:

As banking has evolved over the last three decades, banks have be-come increasingly interconnected. This Article draws attention to an effect of this development that has important policy ramifications yet remains largely unexamined?a dramatic rise in interbank discipline. The Article demonstrates that today?s large, complex banks have financial incentives to monitor risk-taking at other banks, the infrastructure, competence and information to be fairly effective monitors, and mechanisms through which they can respond when a bank changes its risk profile.

The rise of interbank discipline has both positive and negative ramifications from a social welfare perspective. The good news is that self-interested banks may be expected to penalize a bank when it takes excessive risks, thereby deterring such risk taking. The bad news is that the interests of banks and society are not always so well aligned. Other banks, for example, may be expected to reward a bank when it changes its risk profile in a way that increases the probability that the government would bail the bank out rather than allowing it to fail. This is because a bailout protects a bank?s creditors, even though it is socially costly. Interbank discipline may thus encourage banks to alter their activities in ways that increase systemic fragility.

In drawing attention to the powerful yet mixed effects of interbank discipline on bank activity, this Article contributes to a new generation of scholarship on market discipline. Its aim is not to question whether we need regulation, but to address the pressing issue of how we should allocate inherently finite regulatory resources. It suggests that by reducing the regulatory resources devoted to activities that other banks are performing relatively well, increasing the resources devoted to activities that regulators are uniquely situated or incentivized to address, and seeking to counteract the adverse effects of interbank discipline, bank oversight could be redesigned to more effectively promote the stability of the financial system.

The paper is a valuable springboard for talking about the flip side of bank ?interconnectedness? ? not merely as transmission lines for contagion, but as a crucial feature of market and regulatory architecture.

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Source: http://www.theconglomerate.org/2012/11/judge-on-interbank-discipline.html

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