During the financial crisis bank were not regulated properly therefore took uncontrollable risk which showed a lack of market discipline. If information was symmetrical between banks and investors and stricter regulation in place the financial crisis might have been prevented.
I understand market discipline to be, free market forces which help limit the risks taken by banks regarding investment from stakeholders and who they borrow money to.
(Crockett 2001) identified four requisites for effective market discipline which are information in order to understand the risk, ability to process the information, incentives to want to rein in undue risk taking and power to exercise discipline over bank .These four requisites are heavily linked to each other.
Investors in banks require adequate information in order to be able to assess the risks they are exposed to. Investors had asymmetric information therefore were unable to assess the risks, has banks disclosed minimal information to them. During the crisis investors realised they didn’t have enough information, this caused a dramatic increase in funding costs intensifying the crisis(Gorton 2008). Levels of high complacency were caused by banks underpricing risk or ignoring them all together therefore giving investors a false sense of security.
(Morris and Shin 2002) “show that greater disclosure may be harmful because it induces market participants to put excessive weight on the public information”.This resulted in limited information being provided during crisis, which resulted inability to asses the risk taken previously. If public information isn’t accurate this can further worsens market discipline as they rely heavily on this.
Investors require sufficient amount of information in a simple format, in order to be able process the information effectively in order to evaluate the quality of their investment. Due to the fact information between banks and investors were asymmetric this affected the ability of the investors to process their investment opportunity. It becomes more difficult to evaluate risk when data is crowded, furthermore the fact that manager withheld also intensify the inability if investor process the information properly. (Thakor 2015) “analytically predicts that mandatory disclosure for financial institutions might be inefficient and make banks more fragile”. Therefore, it may still have a negative impact whether bank disclosures the information or not as people withdrawing their money might crumble banks but investors don’t lose their money incase of another financial crisis.
Debt investors calculate the risks compared to potentially profit that can be gained. Therefore market discipline can be undermined if there a huge difference between the risks the banks are taking versus the risk the debt investors are taking. Government allowing specific banks to collapse would result in astonishing high economic cost, therefore meaning these banks can’t fail. Government intervention takes place which provides guarantees for these large banks, meaning they are covered for specific losses. Banks who are insured against all or some losses, this incentivises them to take more risks than your average banks, therefore this has an opposite effect of trying to rein in risk as they have more roam for error and aren’t held accountable.
Investors have the power to regulate the bank, they have the ability to influence manager in multiple ways depending on what type of holders they are either equity or debt. Equity holders have the capability to directly influence managers through voting against their proposed actions in shareholder meeting, compared to debt holders can only indirectly influence managers by demanding higher returns to hold the banks debt, this increase the price of taking risks and make managers less adventurous. Investors regulate banks to ensure their investments are safe and risk tasking is kept to a minimal. Leading up to the financial crisis this wasn’t done enough therefore resulting in extreme risk taking.
Market discipline plays a key role in the banking sector, a lack of market discipline had a huge contribution to the build up of the financial crisis. Due to asymmetrical information provided by the banks, this persuaded investors to take more risks with their investment. Disclosure of information meant investors couldn’t assess the risk properly and government intervention meant banks took bigger risks as they knew they were going to get bailed out.
Market discipline cannot be singled out as the only factor that could have prevented the financial crisis from happening but I believe the collapse of the economy was caused by a breakdown of the market discipline and lack of banking regulations in place