Preferred Sources of Market Discipline

Abstract

The 1980s was a turbulent period for the financial services industry. The federal safety net-particularly deposit insurance-which was heralded by many for sustaining industry stability for nearly half a century, was suddenly criticized as a major cause of many of the industry's problems. In response to numerous proposals to modify the safety net, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The new legislation emphasized the need to reform the safety net by shifting more of the risk of bank failures to depositors and away from the insurance fund and taxpayers. In a previous article appearing in this Journal, Professor Krishna Mantripragada discussed the costs and benefits of depositor discipline and evaluated the attributes of moving from the dollar-based insurance of FDICIA to a maturity-based coverage that insured only short-term deposits. In this Article, Mr. Evanoff expands the discussion of market discipline and recommends an adjustment to the current bank regulatory structure that utilizes an alternative form of discipline. Evanoff emphasizes the unique attributes of subordinated debt and claims that a regulatory structure relying on an increased role for subordinated debt in banks' capital structure requirements would be preferable to either the size- or maturity-based forms of depositor discipline. He contrasts the effectiveness of the proposed regulatory structure with alternatives relying on depositor-imposed market discipline by analyzing the behavioral changes the proposed structure would instill in bankers, depositors, and regulators.

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