First draft. Comments welcome. DEPOSITOR BEHAVIOR AND MARKET DISCIPLINE IN COLOMBIA

This empirical study examines how the public makes decisions to place deposits among different banks and over time in the Colombian banking system. Recent studies suggest that in several Latin American countries, depositors exhibit significant responsiveness to performance indicators. With our specification, we set out to control for a more comprehensive set of risk/return factors, and thus conduct a stronger test for market discipline. We incorporate variables reflecting return to deposits (interest rate, noninterest services provided, etc.) as well as those reflecting risk (non-performing loans, capital-to-asset ratio, etc). This specification allows us to answer two types of questions of particular interest in rapidly evolving and liberalizing financial systems: (1) How do banks gain or lose market share? Which specific return or risk factors are the most important in explaining a bank's deposit growth? (2) How well do depositors discriminate between well and poorly managed banks? Using semi-annual data for 1985-1999 we find evidence that the rate of growth of deposits is related to a wide range of proxies for a bank’s probability of default. Furthermore, there is evidence that depositors’ choices effectively discipline banks; following “fundamental-driven” deposit losses, banks tend to respond by improving their capitalization and coverage ratios. Finally, banks with strong fundamentals appear to benefit from lower interest costs. This allows us to conclude that in the case of Colombia, market discipline is strong and that moral hazard stemming from deposit insurance ís limited, perhaps a consequence of certain design features of the insurance scheme. JEL Classification Number: G21