This paper empirically investigates two issues largely unexplored by the literature on market discipline. First, we evaluate the interaction between market discipline and deposit insurance. Secondly, we analyze the impact of banking crises on market discipline. We focus on the experiences of Argentina, Chile, and Mexico during the 1980s and 1990s. Using bank level data for these countries, we find that depositors discipline banks by withdrawing deposits and by requiring higher interest rates. Across countries and across deposit insurance schemes, market discipline exists even among small, insured depositors. Finally, banking crises seem to increase investors responsiveness to bank risk taking.

Abstract: An important question is whether the financial safety net reduces market discipline on bank risk taking. For countries with varying deposit insurance schemes, we find that deposit rates continue to reflect bank riskiness. Cross-country evidence suggests that explicit deposit insurance reduces required deposit interest rates at a cost of reduced market discipline. Internationally, deposit insurance schemes vary widely in their coverage, funding, and management. Hence, there are widely differing views on how deposit insurance should optimally be structured. To inform this debate, we use a newly constructed data set of deposit insurance design features to examine how different design features affect deposit interest rates and market discipline.

In the early 1990s, after decades of high inflation and financial repression, Argentina embarked on a course of macroeconomic and bank regulatory reform. Bank regulatory policy promoted privatization, financial liberalization, and free entry, limited safety net support, and established a novel mix of regulatory and market discipline to ensure stable growth of the banking system during the liberalization process. Argentina suffered some fallout from the Mexican tequila crisis of 1995, but its response to that crisis (allowing weak banks to close) and the redoubling of regulatory efforts to promote market discipline after the crisis made Argentina's banking system quite resilient during the Asian, Russian, and Brazilian crises. Argentina's bank regulatory system now is widely regarded as one of the two or three most successful among emerging market economies. This paper traces the evolution of the regulatory policy changes of the 1990s and shows that the reliance on market discipline has played an important role in prudential regulation by encouraging proper risk management by banks. There is substantial heterogeneity among banks in the interest rates they pay for debt and the rate of growth of their deposits, and that heterogeneity is traceable to fundamental attributes of banks that affect the riskiness of deposits (i.e. asset risk and leverage). Moreover, market perceptions of default risk are mean-reverting, indicating that market discipline encourages banks to respond to increases in default risk by limiting asset risk or lowering leverage. First author : Paul M. Montrone Professor of Finance and Economics, Columbia Business School, Research Associate, National Bureau of Economic Research. Second author : Chief Economist of the Central Bank of Argentina. The views ex...

Explicit deposit insurance has been spreading rapidly in recent years, even to countries with low levels of financial and institutional development. Economic theory indicates that deposit- insurance design features interact--for good or ill--with country-specific elements of the financial and governmental contracting environment. This paper documents the extent of cross-country differences in deposit- insurance design and reviews empirical evidence on how particular design features affect private market discipline, banking stability, financial development, and the effectiveness of crisis resolution. This evidence challenges the wisdom of encouraging countries to adopt explicit deposit insurance without first stopping to assess and remedy weaknesses in their informational and supervisory environments. We would like to thank Thorsten Beck, Jerry Caprio, Stijn Claessens, Ross Levine and Rick Mishkin for valuable discussions. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. 1.

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This paper was prepared for presentation at the 2001 Economic History Association Meetings. Calomiris is the Paul M. Montrone Professor of Finance and Economics at Columbia University, a research associate of the NBER, and a visiting fellow at the American Enterprise Institute. Mason is an Assistant Professor of Finance at Drexel University and a Sloan Fellow at the Wharton Financial Institutions Center. 1 I.

We study the relationship between bank participation in derivatives contracting and bank lending for the period 30 June 1985 through the end of 1992. Since 1985 commercial banks have become active participants in the interest-rate derivative products markets as end-users, or intermediaries, or both. Over much of this period significant changes were made in the composition of bank portfolios. We find that banks using interest-rate derivatives experience greater growth in their commercial and industrial (C&I) loan portfolios than banks that do not use these financial instruments. This result is consistent with the model of Diamond (Review of Economic Studies 51, 1984, 393--414) which predicts that intermediaries' use of derivatives enables increased reliance on

This paper reviews the main results of the economic literature explaining the existence of deposit insurance in its modern form. It is shown that deposit insurance is not the only means to cope with the problem of bank runs. Yet it is a prevailing solution for the banks dominate the credit channels in most economies the world over, and the modern payment systems are based on the convertibility of the bank deposits into cash. Being a part of the general public policy of financial sector stability, deposit insurance is structured in accordance with a core objective adopted for the entire policy, and this explains why many world schemes, besides the intrinsic DIS objective of bank run prevention, also choose to follow the objective of small (unsophisticated) depositor protection. In practice, a trade-off between the ability of a DIS to prevent bank runs and the soundness of incentives it induces forces policymakers to choose between the two objectives. The review of the related literature helps to distinguish four basic approaches regarding the balance of the run-prevention capacity and sound incentives in deposit insurance design. Further analysis also shows that three of the basic structuring options (the limited, partial, and selective guarantees) are likely to be employed in the ordinary (non-crisis) circumstances and the choice among them needs to be based on the country-specific factors.

crisis as a wake-up call. Do banks tighten lending standards during a financial crisis?

We propose to incorporate cross-sectional heterogeneity into structural VARs. Heterogeneity provides an additional dimension along which one can identify structural shocks and perform hypothesis tests. We provide an application to bank runs, based on microeconomic deposit market data. We impose identi…cation restrictions both in the cross-section (across insured and non-insured banks) and across variables (as in macro SVARs). We thus (i) identify bank runs, (ii) quantify the contribution of competing theories, and, (iii) evaluate policies such as deposit insurance. The application suggests substantial promise for the approach and has strong policy implications.