Document Type

Article

Publication Date

2013

Abstract

As banking has evolved over the last three decades, banks have become increasingly interconnected. This Article draws attention to an effect of this development that has important policy ratnifications yet remains largely unexarined a draratic rise in interbank discipline lThe Article demonstrates that today's large, conplex banks have flrancial incentives to monitor risk taking at other banks, They also have the infrastructure, competence, and information required to be fairly effective monitors and mechanisms through which they can reTond when a bank changes its risk profile. Interbank discipline thus affects bank risk taklng, discohuraging banks from taling some types of risk while potentially encouraging the assumption of others. Given its influence, ign)rig the phenmeon can lead to ineffciencies and gaps in bank regulation, The rise of interbank discipline has positive and negative ramifications from a Social wIfare perspective. 'The good niv s is that self interested banks may be expccted to penalize a bank when it takes excessive risks, thereby deterring such risk taking. he bad itvs is that the interests oftbanks and sotiet are not a]hvavsso well alignead Other banks, fir example, may be expected to reward a bank when it changes its risk profile in a way that increases the probability that the government would bail the bank ott rather than allowing it to fail. This is because a bailout protects a banks counterparties and other creditors, even though socially costly Interbank disciplinet ma thus encourage barks to alter their activities in ways that increase systenic fragility.

In drawing attention to the powerful yet mixed effects of interbank discipline on bank activity, this Article contributes to a new generation of scholarship on market discipline. Its aim is not to question whether we need regulation, but to address the pressing issue of how we should allocate inherently finite regulatory resources. By reducing the regulatory resources devoted to activities that other banks are performing relatively well, increasing the resources devoted to activities that regulators are uniquely situated or incented to address and seeking to counteract the adverse effects of interbank discipline, bank oversight could be redesigned to more effectively promote the stability of the financial system.

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This article was originally published in UCLA Law Review.

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