Market discipline

In the second Chapter of the GFDR, we discuss these interventions and examine their impact on market discipline. Market discipline refers to the process by which market participants, such as depositors and shareholders, monitor the risks of banks, and take action to limit excessive risk-taking. Drawing on the literature, we argue that for market discipline to work effectively, market participants must have the information, the means, and, most importantly, the incentives to monitor and influence banks. In other words, market participants must have “skin in the game”. This requires banks that have taken excessive risk to fail and for bank investors and depositors to share the losses when they do. Government interventions in the private market to bail-out large financial institutions have significantly reduced the long-term incentives to monitor and discipline these banks.

In the aftermath of the crisis, following policy goals set by the FSB, a number of countries have introduced legislation and regulatory reforms to address the risk posed by systemically important institutions and to strengthen market discipline. In particular, there were reforms concerning capital and liquidity regulations -increasing capital and liquidity requirements overall, and additional surcharges were instituted for banks deemed systemically important. The focus has also been shifting from supervision to resolution. There are new resolution processes for systemically important banks and new requirements for these institutions to hold so called bail-in debt to aid in the resolution process (Figure 2). New macroprudential rules have also been introduced to enhance risk management and risk reporting processes at banks, including periodic stress tests, to determine whether banks have sufficient capital to absorb losses.

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Figure 2 Requirements implemented for resolving SIFIs

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