How do depositors respond to banks' discretionary behaviors? Evidence from market discipline, deposit insurance, and scale effects

Abstract

We investigate how depositors respond to the U.S. bank's discretionary behaviors. We document higher deposit rates for banks that engage more in earnings management, suggesting evidence of market discipline. The quantile regressions, which dissect bank behavior at the right tail of deposit costs distribution, point out that the leveraged effect of earnings management is more significant in low- and high-deposit costs banks. Additionally, we note that depositors monitor banks' discretionary behavior to a greater extent before and during the crisis; however, they become less severe after the crisis. Interestingly, there is strong evidence of depositors monitoring large banks before, during, and after the crisis, suggesting the “too-big-to-fail” perception does not hold for our sample. The study also documents evidence of monitoring by insured and uninsured depositors over the sample period. After the crisis, we find a “wake-up call” for uninsured depositors, and more importantly, insured depositors remain sensitive to banks' reporting quality despite a weakening of incentives due to the increase of deposit insurance limit. The evidence is crucial when confirming that a deposit insurance scheme does not completely remove the deposit discipline. Our findings are useful for regulators and policymakers concerned about strengthening the market discipline.