The cost of market versus regulatory discipline in banking

Abstract

We present evidence that insured deposit financing shields banks from the full costs of market discipline. Moody's downgrades, indicators of increasing risk, are associated with negative abnormal equity returns that are increasing in the bank's reliance on insured deposits. Moreover, banks raise their use of insured deposits following increases in risk. These findings cast doubt on the ability of capital market participants to effectively discipline bank behavior within the current regulatory environment. More generally, our findings highlight the potential for regulation to undermine market discipline in regulated industries.

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