Opening remarks to "Beyond Pillar 3 in International Banking Regulation: Disclosure and Market Discipline of Financial Firms," a Conference Cosponsored by the Federal Reserve Bank of New York and the Jerome A. Chazen Institute of International Business at Columbia Business School, October 2-3, 2003.Bank supervision ; Banks and banking, International ; Financial institutions - Law and legislation

Jamie B. Stewart, Jr.

English

Research Papers in Economics

FRBNY Economic Policy Review / September 2004 1
am delighted to welcome you today to the Federal 
Reserve Bank of New York and to this conference, 
“Beyond Pillar 3 in International Banking Regulation: 
Disclosure and Market Discipline of Financial Firms.”
I would like to begin by thanking our cosponsor, the Jerome 
A. Chazen Institute of International Business at Columbia 
University’s School of Business. In particular, I want to 
thank Rick Mishkin for his help in organizing this 
conference. Rick is a special friend to many of us here at the 
New York Fed, having served as director of research from 
1994 to 1997 before returning to Columbia as the Alfred 
Lerner Professor of Banking and Financial Institutions at 
the Graduate School of Business.
It is a great pleasure to welcome to the conference such a 
distinguished group of researchers, many of whom have 
contributed in important ways to the literature on market 
discipline and disclosure in the banking industry. I am also 
pleased to see that many of you are bank examiners and 
supervisors. Your presence is very important because, despite 
the academic nature of many of the presentations, the goal of 
this conference is really to inform and improve “best practices” 
in bank regulation and supervision. Having spent a good deal 
of my earlier career in a commercial bank and much of the past 
five years helping to run an institution that supervises banks, 
I have become firmly convinced of the ongoing need for strong 
and effective regulation and supervision.
Before turning the program over to our first speaker,
I would like to make a few observations about the role of 
disclosure and market discipline as it relates to the Basel II 
Accord. As you no doubt know, disclosure and market 
discipline represent the third pillar of Basel II, an ambitious 
initiative to which many at this Bank, and at this conference, 
have contributed enormously. While the first two pillars—
which relate to capital requirements and the supervisory review 
of capital adequacy—have been much discussed, a consensus is 
emerging that the third pillar merits additional attention. 
Indeed, it is because we share this view that we have organized 
this conference, devoted entirely to the topic of market 
discipline and disclosure.
What are we really getting at when we talk about disclosure 
and market discipline? “Disclosure” has been in the press a lot 
since Enron and other corporate scandals came to light. But 
with banks, transparency—or opacity—has always been an 
issue. Some people see banks as black boxes. Money flows in 
and money flows out, but the risks taken in the process of 
intermediation can be difficult to observe from the outside. Let 
us suppose, then, that banks are more opaque than other kinds 
of firms. Is that opacity inherent in the business of banks, or has 
the government safety net—deposit insurance, access to a 
lender of last resort, and the possibility of bailouts—essentially 
made banks opaque, removing them from investor scrutiny 
and allowing the effectiveness of their risk management 
Jamie B. Stewart, Jr.
Opening Remarks
Jamie B. Stewart, Jr., served as first vice president of the Federal Reserve Bank 
of New York from 1999 through early 2004.
I2 Opening Remarks
strategies to go unmonitored? In other words, is the veil 
between banks and the public an inevitable consequence of the 
business itself, or just the other side of the safety net? 
Deliberations at this conference will help illuminate this 
question.
And what about market discipline—the other issue at this 
conference? Market discipline is a complex concept that can 
mean different things to different people. Allow me to make 
some distinctions that may prove useful over the course of the 
conference.
The issue of market discipline of banks is often confused 
with the issue of corporate governance. These issues are related, 
but there is a subtle difference. Strictly speaking, corporate 
governance is about safeguarding the interests of firm owners—
the shareholders. Market discipline, as applied to banks, is 
about safeguarding the interests of depositors and their insurer, 
the Federal Deposit Insurance Corporation. As is well known, 
deposit insurance may invite excessive risk taking by bank 
owners. Excessive risk harms the FDIC and uninsured 
bondholders alike. The discipline that bank bondholders apply 
in protecting their own interests should protect FDIC interests 
as well. Monitoring by bondholders, in other words, can 
protect FDIC interests just as monitoring by a corporate board 
is supposed to protect shareholder interests. In that sense, 
market discipline and corporate governance are related, but 
different.
As today’s first paper will make clear, market discipline can 
function either as a substitute for or as a complement to 
government supervision. Instead of laboriously examining 
individual bank assets, supervisors may be able to rely to some 
extent on bond spreads or stock prices as signals of a bank’s 
relative risk. Information produced by market analysts, in 
other words, may substitute for information produced by 
supervisors. By contrast, a visible collapse in bank bond or 
stock prices may force regulators to take action. In this sense, it 
is possible to think about the market disciplining the regulators 
rather than the banks.
Discipline can come at different stages. In principle, 
investors should monitor banks’ lending or portfolio strategies 
and penalize shifts toward riskier strategies. We can call that 
ex ante discipline. Ex post discipline occurs if and when 
problems arise. Once investors recognize a problem, the higher 
spreads they will command may force troubled banks to 
rethink asset strategies, reshuffle management, or alter funding 
choices. Of course, the extent to which investors actually do 
influence bank owners and management is arguable, as you will 
see in the conference papers.
Different markets can provide different sources of 
discipline. Bond markets are usually considered the first line 
of market discipline because bondholders’ concerns about 
downside risk are aligned in some measure with the interests of 
supervisors and insurers. Stock investors gain more on upside 
risks, but their views can still inform supervisors and provide 
market discipline. One issue currently under consideration by 
economists here is the extent to which spreads on bank loans—
the primary asset of banks—can provide information about 
bank risk for supervisors and outside investors. All of these 
issues will get a good airing in our sessions today and 
tomorrow.
As we take part in these discussions, however, bear in mind 
that market discipline is not always perfect. Did the banking 
crises in Latin America and Southeast Asia in the 1980s and 
1990s reflect too much market discipline, too little, or just the 
wrong kind? Market discipline can also be subverted, as the 
recent accounting and governance scandals in this country 
have made all too clear. Government discipline can be 
undermined as well, of course. As one paper today argues, 
supervisory actions can be postponed for political reasons. 
Clearly, our goal should be to get the right amount and mix of 
discipline—market and government—at the least cost.
I have tried to highlight just a few of the issues to be 
considered over the next two days. I am delighted you are all 
here, and I look forward to hearing your views and exchanging 
ideas with you.

Opening remarks

http://www.newyorkfed.org/research/epr/04v10n2/0409stew.pdf

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