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Bank moral hazard and market discipline

Carletti, Elena (1999) Bank moral hazard and market discipline. Financial Markets Group Discussion Papers (326). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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We show that market discipline can be effective in resolving the moral hazard problem which arises when depositors do not know whether bankers are monitoring or not the projects they finance. Demandable debt, by allowing the possibility of bank runs, can induce bankers to monitor. However, market discipline comes at a cost. When depositors are not equally informed about the future value of bank assets, withdrawals caused by a liquidity shock may be confused with future insolvency and cause uninformed depositors to precipitate a run. Likewise, withdrawals due to upcoming insolvency may be confused with a liquidity shock and dissuade depositors from running. Bank runs are, therefore, costly and imperfect disciplinary devices for bankers. Our results offer a new perspective on the debate on market versus regulatory discipline of banks.

Item Type: Monograph (Discussion Paper)
Official URL:
Additional Information: © 1999 The Authors
Divisions: Financial Markets Group
Subjects: H Social Sciences > HC Economic History and Conditions
H Social Sciences > HG Finance
JEL classification: G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation
G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure
Date Deposited: 04 Jul 2023 13:33
Last Modified: 16 May 2024 12:30

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