Market discipline and subordinated debt: A review of some salient issues

Academics and regulatory economists have long been concerned that mispriced deposit insurance undermines monitoring of banks by investors and increases incentives for bank risk-taking. Government supervision provides a partial substitute for the private corporate governance services provided by a firm.s shareholders and creditors. As financial firms have become more complex, however, government supervisors have found it more difficult to monitor them in a timely manner. This is particularly true of large, complex banking organizations. Accordingly, many analysts.both inside and outside the regulatory agencies.have suggested that supervisors should rely on .market discipline. to supplement their traditional supervisory methods (Meyer, 1999). The Basel Committee on Banking Supervision.s consultative paper on capital adequacy (Basel Committee, 1999) asserts that .[m]arket discipline imposes strong incentives on banks to conduct their business in a safe, sound, and efficient manner,. and designates market discipline as one of the three pillars on which future financial regulation should be based. (The other two pillars are minimum capital standards and supervisory review of capital adequacy.)