Market discipline in the Latin American banking system: Testing depositor discipline, borrower discipline, and the internal capital market hypothesis

Abstract

This paper tests the existence of market discipline in the Latin American banking system using a variety of methods. It re-examines traditional tests on depositor discipline, controlling banks’ internal capital demand. In addition, it explores whether borrowers discipline bank risk-taking. This new hypothesis points out that low-quality banks issue fewer loans and charge lower interests rates. Contrary to the general view, our findings suggest weak presence of market discipline. These results are robust to different indicators of the key explanatory variables and econometric methods. For policymakers, this implies a necessity to restore market discipline following the Basel Accord.