Market discipline has evolved from the real need to address the financial concerns that brought on the last few financial crises. The international economy is tied deeply to the financial sector, and international organizations such as the International Monetary Fund and the World Bank have been tasked with providing ease of liquidity throughout the world, while also helping to protect the flow of capital across borders to facilitate trade. These financial institutions are remarkably limited to what they can do because they hold little sovereignty over the independent nation-states that compose them; only the World Bank is effective when dealing with trade issues. Instead, individual nations have been given the job of creating regulatory environments to protect the public from a general financial collapse. Alongside growing regulation, a new concept called ‘market discipline’ has emerged, where financial institutions have become increasingly more aware of the needs of their shareholders. Essentially, market discipline for a bank or other financial institution is very similar to the growing corporate responsibility trend in the private sector. However, instead of engaging in philanthropy, financial institutions work to improve the general community by reducing the risk that they take on in order to ensure a steady stream of profits and healthy growth, compared to instability and financial bubbles. While many believe that market discipline can be an effective counter-measure to government regulation, the trend presented by historical evidence shows that that assumption can be dangerous because the financial market acts in its best interest.
When businesses fail, the only people who receive a loss are its employees and shareholders, along with anyone who uses the product or service. However, when international financial companies fail, millions can be affected by the reduction in capital and entire economic systems can collapse. The International Financial Crisis in the year 2008 was caused in large part because of how financial institutions loaned money to home owners. These institutions capitalized on rising housing prices and views mortgages as assets, as foreclosing on houses would net the banks a serious financial gain. However, when the market crashed and many became delinquent on loans where the asset was worth a fraction of the money loaned, the banks lost a serious amount of money. This led to a series of regulations implemented in the United States to help alleviate concerns over the integrity of financial institutions to protect the interests of the public.
Some of these measures included bailing the banks out, leading to the phrase “too big to fail” (Barth & Wihlborg, n.d.). The Barth and Wihlborg study reflected that many of the measures implemented only enjoyed moderate success; in addition, the authors made a compelling argument about the difficulties in accurately predicting the risk each individual banking institution carries. Attempting to address the issue has led to governments attempting to restrict the size of banks and their scope, or by providing banks with recovery procedures. The Dodd-Frank Act encompassed all of these procedures. Banks now have a system to protect their financiers through the federal government, which guarantees a specific amount from being lost by bank failures. The question the government should be asking is whether or not that will incentivize the financial institutions to act recklessly on the market.
The belief in market discipline appears to have originated after the subprime mortgage crisis and the resulting credit crisis that occurred as a result of poor lending and banks placing the risk on unsecured pension funds (Kashyap, Rajan, & Stein, 2008). This was caused in part by the banks’ reliance on short-term funds lent by other institutions. In order to better protect people from a financial problem, this issue should be studied and the leading trend discovered. It would appear as if regulatory powers need to find a way to make this risk smaller in order to better protect people, but market discipline has not caused a decrease in this before and might be unlikely to change it in the future. Governing agencies creating a reserve requirement in the past to help deal with this, but it is clearly still an issue. Kashyap and others have outlined another method: creating banking insurance. Banking insurance would function just like insurance for a home or a car. When a crisis hits, banks receive money and funds to help cover costs. However, one really big problem with this program is that these institutions require capital, which means that said insurance company must hold onto a massive fortune to be able to support the entire banking economy. This is clearly problematic and would not be an effective means of preventing future crises. This is deposit insurance in literal terms; it is commonplace, but typically refers to central governments backing the money placed into the bank by ordinary citizens. The Angkinand and Wihlborg study (2010) fund a strong correlation between depositor’s insurance provided by federal institutions and the increase in risk-taking from financial institutions. This is very problematic, considering that regulation is supposed to be the answer to the problem.
Thus, the need for an alternative to financial regulation is clear and present, as regulation typically stifles business incentives and does not prevent economic problems because all private institutions are profit maximizers. Even regulatory laws were not enough to prevent the Wells Fargo scandal from happening, which was the result of the company using competition to push employees to make unethical choices. Regulatory actions can only go so far to prevent the next crisis. Many place blame on rating agencies that determine the viability of loans or other securities, saying that if those were corrected, people would not have such large risk facing them when deciding on here to place their hard-earned money.
The solution to the problem is one of both regulation and market discipline; essentially, it should be possible to create market discipline through proper regulation. This could easily be accomplished by holding security ratings to higher standards, forcing financial companies to do the same. If AAA ratings held higher standards, investors would not be likely to place their money in institutions that purchase other types of securities, bonds, loans, etc. Security is very important, and the government can use regulation to induce a certain focus on the importance of security to influence how investors consider financial institutions. This means that regulation would drive competition, as each institution would be forced to adhere to the safety standard or risk losing money and accounts to other banks that place a higher importance on reduced risk. This would mean being very careful not to disturb the balance between too much risk and not enough, as institutions need to continue to make money in order to appease shareholders. This means risk is good and necessary, just not excess amounts, like those that helped cause the last financial crisis.
It should be noted that some studies suggest that simply introducing tougher risk measurement tools would not produce the intended result (Blundell-Wignall & Roulet, 2013); rather, that they are unsustainable regardless of how strict the independent agency is because there is no accurate method of determining risk. This is certainly true, as the numerous scales that exist have not prevented large scale problems in the past. Suggestions for alternatives include introducing increased regulation that separates the multiple functions of different banks. However, would this truly be effective? The assumption is clearly that a separation of powers would somehow delay or remove the threat of a financial crisis simply because different parts of an organization perform different things. This logic is not effective in any other situation. Therefore there is no reason to believe that it would solve any problem. Rather, the biggest concern that the public should have is that the heads of the banks pursue courses of action that are contrary to what would be the best decision possible. Examples of this range from giving out poorly backed loans to increase the chances that the bank would foreclose on a valuable asset, increasing the short-term lending of the bank substantially, etc. All of these have caused problems for institutions in the past, but regulating banks by separating them would not solve the issue at hand. Therefore, without changing the financial culture in the marketplace, nothing more can be done by governments as the situation requires something stronger and farther reaching than regulation.
Market discipline is the solution only because it is by nature self-regulating, whereas the current international economic situation is not (Haldane, 2012). Market discipline is self-regulating because each financial institution will seek to reduce the negative risk for their client’s benefit as a form of competition, whereas simple regulation has produced negative externalities that have not always protected the depositor. Market discipline requires something a little more important than just the goodwill of the company: it requires complete information from the investor/depositor. While many in the general public simply have no concern about how a bank behaves until it is too late, market discipline requires constant questioning and enforcement from citizens interested. Essentially, these banks and investment centers need to be held accountable for their decisions, like a normal company would be. The European Union mandated that all banks should have a disaster recovery plan in place should the worst happen (Carmassi & John Herring, 2013); should this not be mandated by the individual shareholders of financial/investment organizations?
This means that the best way to ensure that financial institutions do not create future problems searching for profits is to maximize accountability. This could be done through regulation, similar to what the SOX Act did for financial accounting in the US. Financial institutions could be forced to disclose more information about the loans that they distribute, which would likely go a long way towards reducing the financial risk brought on by these banks. However, this would not appropriately prevent investment banks from failing, as these banks have to make risky investments due to their nature. For example, market discipline likely would not have saved Lehman Brothers from collapsing, as the multinational investment bank simply chose poor investments and went under as a result. These banks already have pressure on them to make wise investments, because failure would immediately result in bankruptcy. This means there is little that can be done, regulatory or independent, to help prevent investment banks from collapsing. However market discipline could play a massive role in shaping the future of other financial institutions because the accountability will stem directly from the place where financial institutions receive their money: depositors. Regulation has not yet created an environment that causes the companies to think of those that are directly affected by the failure of the company, but a decreased profit margin certainly will.
Therefore, market discipline is very important in preventing financial crises because it creates a cultural change in the way banks do business. This change is very important because it means that the banking industry will not necessarily be profit maximizers, but protectors of their client’s fortunes and wealth. This shift is absolutely vital because it is the only way to produce long-term prevention in matters of financial bubbles and other problems. It will require a new method of thinking however, which can only be brought on by increasing regulation in order to produce the desired effect. This is because banks previously sought to maximize income in order to appease shareholders by taking on increased financial risk, which led to the last crisis. Now, they will reduce the risk under market discipline to ensure that the stream of profits is consistent and safe. That will require a large shift in thinking, and is only possible by using regulation.
References
Angkinand, A., & Wihlborg, C. (2010). Deposit insurance coverage, ownership, and banks’ risk-taking in emerging markets. Journal of International Money and Finance, 29(2), 252–274. doi:10.1016/j.jimonfin.2009.08.001
Barth, J. R., & Wihlborg, C. (n.d.). Too big to fail: Measures, remedies, and consequences for efficiency and stability. SSRN Electronic Journal. doi:10.2139/ssrn.2841388
Blundell-Wignall, A., & Roulet, C. (2013). Bank business models, capital rules and structural separation policies. Journal of Financial Economic Policy, 5(4), 339–360. doi:10.1108/jfep-06-2013-0025
Carmassi, J., & John Herring, R. (2013). Living wills and cross-border resolution of systemically important banks. Journal of Financial Economic Policy, 5(4), 361–387. doi:10.1108/jfep-07-2013-0030
Haldane, A. (n.d.). The Dog and the Frisbee. Speech; Federal Reserve of Kansas
Kashyap, A., Rajan, R., & Stein, J. (2008). Rethinking Capital Regulation. Federal Reserve of Kansas
