Do Depositors Discipline Banks and Did Government Actions During the Recent Crisis Reduce this Discipline? An International Perspective

Abstract

The recent financial crisis highlights the importance of both regulatory and market discipline. Government reactions to the crisis included expanding deposit insurance coverage and rescuing troubled institutions, including some institutions that might not otherwise be considered too important to fail. These actions may have the unintended consequence of a reduction in market discipline that might otherwise penalize banks for risk-taking behavior. Alternatively, market discipline may have increased during the crisis due to heightened awareness of the risks of bank failures. To address these issues, we first test for the presence of depositor discipline effects in the period leading up to the financial crisis in both the US and the EU. Second, we test whether depositor discipline decreased or increased during the crisis. We find significant depositor discipline prior to the crisis in both the US and EU, but this varies between the US and the EU as well as with banking organization size and with listed versus unlisted status. We also find that depositor discipline mostly decreased during the crisis, except for the case of small US banks.