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4 Yale J. on Reg. 129 (1986-1987)
Banking on the Market: Relying on Depositors to Control Bank Risks

handle is hein.journals/yjor4 and id is 135 raw text is: Banking On the Market: Relying On
Depositors to Control Bank Risks
Helen A. Gartent
The idea of market discipline' is currently very much in vogue in bank-
ing law reform circles.' The notion that bank depositors can be
encouraged to evaluate the risk posture of banks3 in the same way that
securities investors choose stocks borrows heavily from modern financial
theory that has demonstrated that the market for corporate securities is
remarkably efficient in reflecting investors' risk preferences.' In order to
attract deposits, bank management would be forced to limit risk-taking,
t Associate Professor, Rutgers University School of Law at Newark. A.B. 1975, Princeton Univer-
sity; J.D. 1978, Harvard Law School.
Research was supported in part by the Rutgers University Research Council. I would like to thank
John C. Coffee, Jr., Tamar Frankel, Louis Lowenstein, Robert P. Forrestal and his staff at the
Federal Reserve Bank of Atlanta, and my colleagues at Rutgers for invaluable suggestions, and Steven
Klein, Ronald Ladell, and Brian Victor for research assistance.
1. The term market discipline is commonly used as shorthand for the complex process by which
suppliers of capital-here, bank depositors-are believed to make decisions as to their allocation of
funds among investment opportunities. Suppliers of capital will assess alternative investments with a
view to both their expected return-the amount of profits the investment is likely to generate-and
their risk-the probability that such profits will in fact materialize. The greater the risk associated
with a particular investment, the less attractive it becomes to investors, and the higher the return it
must offer in order to tempt anyone to invest. Put another way, depositors should discipline banks
that exhibit too much risk by demanding higher returns, or risk premiums, or by refusing to invest
at all; such banks in turn should be forced to reduce their risk-taking in order to attract and keep
deposits.
2. See, e.g., G. BENSTON, R. EISENBEIS, P. HoRvrrz, E. KANE & G. KAUFMAN, PERSPEcTiVES
ON SAFE AND SOUND BANKING: PAST, PRESENT AND FUTURE 314 (1986) [hereinafter ABA STUDY]
(study commissioned by the American Bankers Association recommending increased reliance on mar-
ket discipline). Even bank regulators have suggested the efficacy of greater reliance on market forces
to control bank risk. See Office of the Comptroller of the Currency, Disclosure of Financial and Other
Information Regarding National Banks, [1984-1985 Transfer Binder] Fed. Banking L. Rep. (CCH)
86,011 (July 16, 1984) [hereinafter Comptroller Statement] (calling for greater disclosure to assist
depositors in making more responsible investment decisions).
3. A bank's risk posture is the degree of risk associated with a depositor's investment in that bank.
This risk arises from the bank's subsequent investment of depositors' funds in loans, securities, and
other ventures. Any increase in the variation of return on the bank's own investment portfolio has a
direct effect on the income prospects of the bank's investors. Thus, depositors have a reason to be
attentive to bank management's risk-taking in order to assess their own risk. See infra text accompa-
nying notes 32-34.
4. Bank depositors have been selected as candidates rather than bank securities holders because
banks rely primarily on deposits for funding; moreover, theoretically at least, bank securities holders
are already exerting discipline. See infra note 29.
5. See generally Lintner, A Model of a Perfectly Functioning Securities Market, in ECONOMIC
POLICY AND THE RE(;ULATION OF CORPORATE SECURITIES 143 (H. Manne ed. 1969); W. LLEWEL-
LEN, THE COST OF CAPITAl. 8-18 (1969).
Copyright 0 1986 by the Yale Journal on Regulation.

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