Private Sector Incentives and Bank Risk Taking: A Test of Market Discipline Hypothesis in Deposit Money Banks in Nigeria

We use panel data of deposit money banks in Nigeria to investigate depositors' reaction to changes in bank risks as proxied by their fundamentals. We are concerned with two questions that are relevant to the design of a new regulatory framework for the Nigerian banking industry: 1) whether depositors respond to bank risk as standard theories predict; and 2) if they do, are such responses strong enough to discipline deposit money banks for excessive risk taking? Using a two-stage framework (monitoring and influence), and a two-channel approach (quantity channel and price channel), our results suggest that deposit growth is sensitive to bank risks. However, the interest rate channel of depositor discipline is not as clear. Only inter-bank deposit interest rate is shown to respond to bank fundamentals. Both total deposit interest rate and time deposit rates are less sensitive to bank fundamentals. Furthermore, there is no evidence that banks do, in fact, respond to signals sent by depositors as suggested by market discipline hypothesis as only interbank interest rates show evidence of mean reversion.