Using Price Information as an Instrument of Market Discipline in Regulating Bank Risk

Abstract

An important trend in bank regulation is greater reliance on market discipline. In particular, information impounded in securities prices is increasingly used to complement supervisory activities of regulators with limited resources. The goal of this paper is to analyze the theoretical foundations of market-based bank regulation. We nd that price information only improves the e ciency of the regulator's monitoring function if the banks' risk-shifting incentives are not too large. Further, if the regulator cannot commit to an ex ante suboptimal auditing policy, market-based bank regulation can lead to more risk taking in equilibrium, increasing the expected payments by the deposit insurance agency. Finally, we show that the regulatory use of market information can decrease the investors' incentives to acquire costly information, thereby reducing the informativeness of stock prices.