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Bank moral hazard and market discipline

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  • Carletti, Elena

Abstract

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.

Suggested Citation

  • Carletti, Elena, 1999. "Bank moral hazard and market discipline," LSE Research Online Documents on Economics 119122, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:119122
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    File URL: http://eprints.lse.ac.uk/119122/
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    Cited by:

    1. Georges Dionne, 2003. "The Foundations of Banks' Risk Regulation: a Review of the Literature," Cahiers de recherche 0346, CIRPEE.

    More about this item

    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
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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