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Best Instruments for Market Discipline in Banking

Author

Listed:
  • Greg Caldwell
Abstract
The author develops a dynamic model of banking competition to determine which capital instrument is most effective in disciplining banks' risk choice. Comparisons are conducted between equity, subordinated debentures (SD), and uninsured deposits (UD) as funding sources. The model, adapted from Repullo (2004), analyzes the effectiveness of regulatory capital when banks incorporate charter value and competition for depositors into their risk-taking decision. The paper's main finding is that although all three instruments can induce market discipline on banks, equity weakly dominates SD and UD (with SD weakly dominating UD).

Suggested Citation

  • Greg Caldwell, 2007. "Best Instruments for Market Discipline in Banking," Staff Working Papers 07-9, Bank of Canada.
    • Handle: RePEc:bca:bocawp:07-9
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    File URL: https://www.bankofcanada.ca/wp-content/uploads/2010/03/wp07-9.pdf
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    References listed on IDEAS

    as
    1. Repullo, Rafael & Elizalde, Abel, 2004. "Economic and Regulatory Capital: What is the Difference?," CEPR Discussion Papers 4770, C.E.P.R. Discussion Papers.
    2. Blum, Jurg M., 2002. "Subordinated debt, market discipline, and banks' risk taking," Journal of Banking & Finance, Elsevier, vol. 26(7), pages 1427-1441, July.
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    5. anonymous, 1999. "Using subordinated debt as an instrument of market discipline," Staff Studies 172, Board of Governors of the Federal Reserve System (U.S.).
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    7. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
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    18. Robert R. Bliss, 2001. "Market discipline and subordinated debt: a review of some salient issues," Economic Perspectives, Federal Reserve Bank of Chicago, vol. 25(Q I), pages 24-45.
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    22. Jones, David, 2000. "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 35-58, January.
    23. Greg Caldwell, 2005. "Subordinated Debt and Market Discipline in Canada," Staff Working Papers 05-40, Bank of Canada.
    24. Marc J. K. De Ceuster & Nancy Masschelein, 2003. "Regulating Banks through Market Discipline: A Survey of the Issues," Journal of Economic Surveys, Wiley Blackwell, vol. 17(5), pages 749-766, December.
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    Cited by:

    1. Elfers, Ferdinand & Koenraadt, Jeroen, 2022. "What you don’t know won’t hurt you: Market monitoring and bank supervisors’ preference for private information," Journal of Banking & Finance, Elsevier, vol. 143(C).
    2. Zhang, Zhichao & Song, Wei & Sun, Xin & Shi, Nan, 2014. "Subordinated debt as instrument of market discipline: Risk sensitivity of sub-debt yield spreads in UK banking," Journal of Economics and Business, Elsevier, vol. 73(C), pages 1-21.
    3. Giuliano Iannotta, 2011. "Market discipline in the banking industry: evidence from spread dispersion," The European Journal of Finance, Taylor & Francis Journals, vol. 17(2), pages 111-131.

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    More about this item

    Keywords

    Financial institutions;

    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

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