Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation

By Jean-Charles Rochet | Go to book overview

Chapter Four

Macroeconomic Shocks and Banking Supervision

Jean-Charles Rochet


4.1 Introduction

The spectacular banking crises that many countries have experienced in the last twenty years (see, for example, Lindgren et al. (1996) for a list) have led several bankers, politicians, and economists to advocate increasing the pressure of market discipline on banks, as a complement to prudential regulation and supervision. They argue that the increased complexity of financial markets and banking activities have made traditional centralized regulation insufficient, either because it is too crude (like the Basel Accords of 1988) or too complex to be applicable (like the standardized approach proposed by the Basel Committee to account for market risks in the first revision of the Basel Accords). Moreover, the increase in competition, both among banks and with nonbanks, has made it impossible to maintain the status quo, where banks were protected from competition by regulators, in exchange for accepting some restrictions on their activities.

Subordinated debt (SD) proposals (e.g., Wall 1989; Gorton and Santomero 1990; Evanoff 1993; Calomiris 1998, 1999), whereby commercial banks would be required to issue a minimum amount of subordinated debt on a regular basis, have been put forward in order to implement such an increase in the pressure of market discipline. Indeed, if the bank is forced by regulation to issue SD on a regular basis, it will have incentives not to take too much risk since the cost of issuing new SD increases when the risk profile of the bank increases (direct market discipline). Similarly, if the capital adequacy requirement of the bank depends negatively on the secondary market price of its SD, the bank will have incentives to limit its risk of failure since the price of SD on secondary markets decreases when the risk of failure of the bank increases (indirect market discipline).

However, empirical evidence on the real effectiveness of market discipline is mixed.1 In particular, Flannery and Sorescu (1996) argue that

1See, for example, Flannery (1998) and Sironi (2000) and the references therein.

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