Depositor Discipline at Failing Banks

U ninsured depositors, whose deposits are not fully protected by federal deposit insurance, have an incentive to monitor banks' activities and impose additional funding costs on risky banks. This pricing is a form of market discipline, since the market penalizes banks for taking on greater risk. For banks that become troubled, market discipline can take a more severe form: Market participants may become unwilling to supply uninsured funds at any reasonable price. This study examines the effectiveness of depositor discipline at banks that failed in New England in the early 1990s. With a growing number of commentators advocating an enhanced role for market discipline, it is important to assess the effectiveness of depositor discipline. Many argue that private sector stakeholders can play a significant role in constraining excessive risk-taking and encouraging prudent banking practices. Such discipline is particularly important as a bank approaches insolvency, when managers' aversion to risk can dissipate in a last-chance effort to salvage a failing institution. Given the enormous costs associated with past taxpayer-supported resolutions of financial crises in the United States and abroad, the potential effects depositors can have on bank behavior as a bank approaches insolvency is an important area of study. A recent study by Billett, Garfinkel, and O'Neal (1998) raises a concern about the effectiveness of depositor discipline. The authors find that banks whose debt is downgraded by Moody's subsequently increase their use of insured deposits. This finding suggests that an increase in the required return on uninsured deposits, or the withdrawal of uninsured deposits, may have only a limited effect on banks' operating decisions. Since banks can turn to the insured deposit market, troubled banks may face only minor funding constraints. This study extends their work by considering the use of insured and uninsured deposits at failing banks. The empirical analysis examines whether failing banks in New England faced depositor discipline as they became troubled in the early 1990s, and