Testing the Strength of Market Discipline in Some Developing Countries

Abstract

In the current paper we examine the two major hypotheses related with depositor discipline. The first hypothesis is called ‘the interest rest channel’-hypothesis. The second one is called ‘the deposit growth rate channel’- hypothesis. According to the first hypothesis, if depositor discipline is at work, as some of us believe, then a decrease in the quality of assets of banks should be accompanied by an increase in interest rate asked for by the depositors. Why? Because depositors, like other investors, will like to be compensated for taking higher risk. Otherwise, they will invest in less risky banks even if those banks have lower interest rate. This is perfectly rationale. According to ‘the deposit growth rate’ channel hypothesis, if quality of assets held by banks decrease, then depositors should punish the banks by withdrawing deposits. As a result, growth of total deposit should decrease. In the present paper we explore both of these channels with the help of a multi-country panel data set and find evidence that both of these channels work. This knowledge of the vital role played by depositor discipline is especially important today when the banking sector of many countries around the world is in trouble. Policy makers and regulators should take steps to develop and enhance depositor discipline even further. This will go a long way to help overcome both the adverse selection and moral hazard problem in the loan market.