Interbank Discipline

This post comes to us from Kathryn Judge, an Associate Professor of Law at Columbia Law School.

In the paper Interbank Discipline, recently posted on SSRN and forthcoming in the UCLA Law Review, I examine the increasingly important role that banks play monitoring and disciplining other banks. As a result of the transformation of banking over the last three decades, today’s complex banks typically have numerous relationships with other banks. As a result of transactions ranging from short-term loans to swaps and repurchase agreements, other banks and financial institutions are often the number one source of credit exposure for complex banks. Recently released data suggest that the largest banks regularly have individual counterparty exposures at levels approaching 25% of their regulatory capital. While the transformation of banking has been widely acknowledged, the correspondent rise in interbank discipline has gone relatively unexamined. In drawing attention to this phenomenon, the paper makes two contributions—it suggests that market discipline may be far more robust than is commonly appreciated and that the effects of market discipline may be more mixed than some of its advocates acknowledge.

There is a large body of literature on market discipline and it is one of the three pillars underlying the more recent Basel Accords. Nonetheless, most discussions of market discipline overlook the important role played by banks. Much of that work focuses on the incentives of a constituency identifiable on a bank’s balance sheet, like holders of subordinated debt or CoCos, to monitor and discipline a bank’s risk taking. Other commentators have recognized that banks may be particularly well suited to monitor risk taking at other banks, but because they were writing at a time when banks were less connected or because they focused on a single dimension of bank connectedness, they generally conclude that some policy change is required for banks to have sufficient economic incentives to discipline other banks. The paper suggests otherwise. Drawing on information about banks’ industry exposures, individual bank-to-bank exposures, and the operational and other risks that can also arise from interbank exposures, the paper reveals that banks already have strong economic incentives to monitor and respond to risk taking at other banks. The paper further suggests that banks have the infrastructure, information, and capabilities needed to be relatively effective monitors, and mechanisms through which they can respond when a bank changes its risk profile. This does not mean that banks are perfect disciplinarians, but it does suggest that they are sufficiently effective to meaningfully impact risk taking at other banks.

The paper also sheds light on the mixed effects of interbank discipline. Market discipline clearly serves a socially useful function. A bank’s counterparties and other creditors should penalize the bank when it assumes excessive risks, thereby discouraging such risk taking. The self-serving interests of market participants, however, are not always socially optimal. While this has been recognized with respect to particular constituencies (primarily shareholders) and with respect to particular risks (primarily liquidity) the paper suggests yet other ways that market discipline may encourage banks to alter their activities in ways that increase systemic fragility.

Another significant discrepancy between the interests of banks and society arises from the possibility that the government will bail out a bank to avert the social costs of allowing it to fail. Recognizing this possibility, a bank’s counterparties and other creditors adjust their willingness to work with a bank based upon their assessment of the probability that the government would intervene on the bank’s behalf. A bank’s status as “too big to fail” has long been recognized as basis for government intervention, and thus is the type of attribute that interbank discipline may reward. Moreover, the recent crisis revealed that the government may feel similarly compelled to intervene when a bank is too interconnected or too correlated to fail and interbank discipline may play a uniquely important role in encouraging a bank to become both. With respect to interconnectedness, a bank doubly benefits when it enters into a new relationship with another bank—the bank itself becomes more interconnected, and thus more likely to receive a bailout, and the same is true for the other bank, reducing the effective credit risk assumed. Similarly, in order to evaluate whether a bank is too correlated to fail, a creditor must not only assess the risks to which the bank is exposed, but also the risk exposures of other banks. A typical subordinated debt holder is unlikely to engage in such diligence. A typical bank, by contrast, is already working with most of the other major banks, and thus already has the information necessary to make the assessment and respond accordingly.

The paper concludes by addressing the policy implications of the rise in interbank discipline. The main claim is that we should rethink bank examination priorities in light of this phenomenon. By analyzing the relative institutional competence of banks and bank examiners, the paper suggests that we should reduce the resources devoted to activities that banks are performing well and increase the resources devoted to activities that bank regulators are particularly well suited or incentivized to undertake. The paper also suggests other policy responses, including ways to better utilize the information created by the interbank market and suggesting that it may be time to fundamentally rethink the purpose of bank examinations in light of interbank discipline and the transformation of banking underlying this phenomenon.

The full paper is available for download here.

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