Market Discipline and Bank Diversification

Can banks be induced to adopt an efficient risk-taking via market discipline? We seek an answer to this question within the context of banks diversifying into the other bank’s asset, which may potentially intensify a systemic risk. The central results of the paper are as follows. When creditors punish the bank’s excessive risk exposure by demanding higher risk premium, the bank owners’ optimal diversification will coincide with the diversification that maximizes the combined value of debt and equity. However, market discipline is effective in aligning the bank shareholders’ interest to that of the creditors only when the bank leverage ratios are at some modest levels. In addition, the effectiveness improves when diversification through securitization is allowed since tranching bank debt into a senior and a junior tranches enables avoiding the dark side of diversification and hence ensures both the individual and social optimality. While supporting capital adequacy and disclosure requirements of Basel III, our analysis warns the consequence of public backstops, that feeds the notion of ‘too-big-to-fail’, in undermining creditors’ incentive to monitor the banks and hence encouraging the latter to adopt excessive and socially sub-optimal risk-taking.