Market discipline: A theoretical framework for regulatory policy development

Given current debates on the future direction of regulatory design, the first objective of this paper is to contextualise the issues surrounding bank market discipline. Accordingly, the paper raises awareness of the current key themes within incentive-based regulatory design and analyses the theory underlying market discipline. This leads to the creation of a theoretical framework of market discipline, which provides a useful tool for understanding the conditions necessary for effective market discipline, and for assessing the findings of market discipline-related empirical research. The second objective is to emphasise the suitability of the theoretical framework to debates on contemporary market discipline and its potential role in aiding future bank regulatory policy design. In particular, it provides support for a mandatory subordinated debt policy, clarifies the roles for market and regulatory authority discipline in bank regulation and suggests the need to incorporate additional incentive mechanisms in the New Basel Capital Accord.