Market Discipline, Disclosure and Moral Hazard in Banking

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Abstract
This paper investigates the effectiveness of market discipline in limiting excessive risk-taking by banks. We have constructed a large cross-country panel data set consisting of observations on 729 individual banks from 32 different countries over the years 1993 to 2000. Theory implies that the strength of market discipline ought to be related to the extent of the government safety net, the observability of bank risk choices and to the proportion of uninsured liabilities in the bank's balance sheet. We test for hypotheses relating to all of these factors at the bank level. Panel data estimation techniques are applied to both capital regressions, which aim to explain banks' choice of capital buffers, and risk regressions, which aim to explain bank risk. Our results suggest that moral hazard exists and that market discipline plays a role in mitigating banks' risk of insolvency.