Can delegating bank regulation to market forces really work?

Abstract

A major theme in the literature on bank regulation is that greater reliance on market forces can mitigate the moral hazard problem inherent in government sponsored deposit insurance. Specific proposals to impose greater market discipline on banks include minimum requirements on (1) uninsured subordinated debt financing (either fixed-term or with option-type features), and (2) private coinsurance on deposits. Both proposals amount to delegating the responsibility for bank regulation to various private sector claimholders. The results suggest that such delegation (with or without claims that include option-type features) may be ineffective in lowering bank risk, at least within the present regulatory and institutional framework. Alternative mechanisms exist that can mitigate the moral hazard problem; however, it may be necessary for the regulator/deposit insurer to be an integral part of the solution.

Citation

Sealey, C.W. (2008), "Can delegating bank regulation to market forces really work?", Chen, A.H. (Ed.) Research in Finance (Research in Finance, Vol. 24), Emerald Group Publishing Limited, Leeds, pp. 27-56. https://doi.org/10.1016/S0196-3821(07)00202-X