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Understanding the failures of market discipline.

"Market discipline"--the theory that short-term creditors can efficiently rein in bank risk through their self-interested actions--has been a central pillar of banking regulation since the late 1980s, both in the United States and abroad. While market discipline did not prevent the buildup of bank risk that caused the recent financial crisis, the conventional wisdom has been that this failure was due to extrinsic factors that impeded the effective operation of market discipline, rather than any underlying problems with the theory itself As a result, policymakers have increased regulatory reliance on market discipline, making this a central part of their reform efforts. This Article challenges the prevailing wisdom and makes two contributions to the literature. First, I demonstrate that market discipline failed more severely and completely than has previously been acknowledged. A foundational premise of market discipline is that investors will signal elevated bank risk through higher prices and lower liquidity. But as I illustrate, there was no such reaction until after the financial crisis had already begun, despite historically high levels of bank riskSecond, I attempt to explain why market discipline failed so completely and fundamentally. I contend that the theory of market discipline relies too heavily on investors that are relatively insensitive to risk and thus serve as particularly poor monitors of banks, and wrongly ignores the effects of bank shareholders, who are highly risk-sensitive but may have incentives adverse to those of public policy. Both of these flaws with the doctrine of market discipline arise from its conflation of capital market investors, who generally are quite sensitive to risk, and purchasers of money instruments, who generally are not. Despite these enormous flaws with the underlying doctrine, improving the conditions for market discipline continues to be seen as a panacea for reducing systemic risk, thus increasing the likelihood that regulators may again be blindsided by another financial crisis.

TABLE OF CONTENTS

  I. INTRODUCTION.
 II. THE LAW AND ECONOMICS OF MARKET DISCIPLINE
       A. Federal Deposit Insurance and the Problem of Banking
          Panics
       B. Market Discipline as a Critique of Government
          Guarantees
       C. The Pre-Crisis Literature on Market Discipline
          1. Are Investors Able to Monitor Risky Banks?
          2. Does Market Discipline Affect Bank Risk-Taking?
          3. Strong Form vs. Weak Form Market Discipline
III. The Failure of Market Discipline
       A. The Implementation of Weak Form Market Discipline
       B. Shadow Banking and the Reemergence of Strong Form
          Discipline
          1. Limited Government Intervention in Shadow
             Banking
          2. Shadow Banking Investors A re Institutional, Not
             Retail
          3. Delegated Monitors to Ameliorate Information
             Asymmetry Issues
       C. The Failure of Markets to Signal Excessive Risk.
          1. Liabilities of Individual Banks Failed to Timely
             Identify Risk
          2. Interbank Borrowing Rates Failed to Timely Signal
             Systemic Risk
          3. Market Pricing of ABS Failed to Timely Signal
             Systemic Risk
          4. Clear Evidence of Bank Risk Prior to July 2007

IV. WHY DID MARKET DISCIPLINE FAIL?
      A. Rejecting the Standard Accounts of Market Discipline's
         Failure
      B. Distinguishing Between Investment Securities and Money
         Instruments
      C. Market Discipline Relies Heavily on Money Instruments
      D. Market Discipline Ignores Risk-Sensitive Shareholders
      E. Procyclicality and Market Discipline
      F. Reconciling the Empirical Findings
  V. TOWARDS A NEW MARKET DISCIPLINE.
      A. Implications for Financial Regulatory Reform
         1. Eliminating Expectations of Government Support is
            Unlikely to Fix Market Discipline
         2. Increasing Issuance of Long- Term Debt
         3. Improving Transparency
      B. Delinking the Incentives of Managers and Shareholders
      C. Reducing Reliance on Market Discipline
         1. Increasing Capital Requirements
         2. Reducing the Size and Complexity of Financial
            Institutions
 VI. CONCLUSION


I. INTRODUCTION

The theory of market discipline, which generally asserts that self-interested creditors can provide substantial assistance in reining in the risk-taking of banks, has been a foundational principle of bank prudential regulation since at least the late 1980s. (1) Since that time, this doctrine has become even more important as the principle of market discipline now stands as one of the three so-called "pillars" of banking regulation articulated by the influential Basel Committee, which sets the international standards for prudential regulation of financial firms. (2) Following the financial crisis of 2007-2008, market discipline has been utilized to an even greater extent as a way to augment and improve the regulation of financial intermediaries. (3) As financial institutions have become too large and complex for regulators to understand and oversee on their own, regulators have come to rely heavily on market discipline, both to directly rein in bank risk and to provide them with important pricing signals of which institutions may be seen as higher risk by the markets. (4)

Clearly, market discipline did not succeed in preventing the buildup of bank risk that caused the financial crisis. However, the consensus among most banking regulators and academics is that the failure of market discipline in this regard was due to some structural impediment, such as the presence of implicit guarantees creating moral hazard or informational asymmetries in financial intermediation, which impeded bank creditors from effectively monitoring and influencing bank behavior. (5) In other words, under this view, market discipline did not fail, but rather policymakers and regulators failed in establishing the predicate conditions for market discipline to be successful.

Based in large part on this diagnosis, one of the ways in which policymakers have sought to reform financial regulation has been to call for measures meant to improve the conditions for market discipline, with the goal of increasing its effectiveness. Both Dodd-Frank and Basel III explicitly call for enhanced market discipline, and federal banking regulators have unveiled a number of measures meant to increase reliance on market discipline, as described in greater detail below. (6)

But as this Article demonstrates, this conventional wisdom is wrong, as the doctrine of market discipline failed completely, in a manner inconsistent with these explanations. Investor and market reactions did not, as many advocates of market discipline predicted, prevent the buildup of risk that caused the crisis, a fact that is fairly indisputable. But more troublingly, as this Article demonstrates, the bank (7) creditors and counterparties that were supposed to exert market discipline failed to even respond to heightened bank risk until it was too late.

As Part II of this Article describes, market discipline was supposed to reduce bank risk through two main effects. First, the reactions of interested investors--withdrawing funds and/or demanding higher rates of return from banks taking on greater levels of risk--were themselves supposed to act as a check on the behavior of bank managers, by providing a deterrent (less availability and a higher cost of funds) to taking on greater risk. Second, these market reactions would help to identify risky banks for regulators, who could use these pricing and liquidity signals as a basis for taking early regulatory action against risky institutions, before that risk manifested itself into insolvency. Part II also provides a general overview of the parameters of the doctrine of market discipline, and reviews the precrisis empirical and theoretical literature on market discipline and its effectiveness in reducing bank risk.

A foundational premise of this theory is that creditors can accurately and timely identify risky financial institutions. This should have been especially true for the period preceding the financial crisis, as the conditions were ripe for the success of market discipline, as I discuss in Part III. The explicit adoption of market discipline as a core pillar of traditional banking regulation beginning in the late 1980s facilitated greater transparency from banks and other financial firms, and created new classes of uninsured creditors who were expected to serve as potent new sources of market discipline. At the same time, the rise of "shadow banking"--credit intermediation that took place primarily in the capital markets and thus outside the prudential regulatory framework established for traditional banking--created arguably the optimal conditions for market discipline to succeed. Shadow banking lacks the distortive government guarantees of traditional banking, and moreover has other key aspects that improve conditions for market discipline, such as sophisticated counterparties and the presence of delegated monitors of risk.

But despite the best possible conditions to date for the success of market discipline, this theory failed systemically and completely, as Part III describes in some detail. Every significant market indicator that might have been relied upon by banking regulators utilizing the theory of market discipline--uninsured deposit rates, bank subordinated debt rates, interbank lending rates, credit default swap prices, and many others--failed to provide any indication of elevated levels of risk until after the 2007-2008 crisis had already started, at which point it was too late for regulators to react effectively.

This is problematic, insofar as there was clear, publicly available, and ample evidence of heightened bank risk, both at specific firms and across the broader banking system, as early as 2005. In short, market discipline failed more completely and systematically than has generally been understood, or at least acknowledged.

Part IV shifts to the question of why market discipline failed. It begins by rejecting the standard accounts for this failure, which largely center upon information asymmetry specific to shadow banking, and moral hazard created by legal or regulatory policies (such as implicit government guarantees for "too big to fail" institutions or bankruptcy laws that favored counterparties in certain types of transactions). As I go over in some detail, these accounts are inconsistent with the actual evidence of the actions (or inactions) taken by bank creditors and counterparties, and thus do not appear to be good explanations of why market discipline did not perform as regulators and policymakers had expected. If these theories were correct, we would have expected to see dampened market reactions to risk, both before and during the crisis. Instead, what we experienced was a nearly complete absence of market sensitivity to bank risk until July 2007, after which point markets became hypersensitive to risk.

Instead, I argue that market discipline failed for two reasons--first, relying on the insights of Eugene Fama's efficient markets hypothesis, the theory of market discipline assumes that all investors in banking liabilities are always risk-sensitive; second, it generally ignores the actions of bank shareholders and the effects these might have on bank risk-taking. Both of these failures are derived from a central problem with market discipline, namely, that it does not distinguish between capital market investors, who generally are quite risk-sensitive, and purchasers of money instruments, who generally are not. Market discipline relies most heavily on the latter, while largely ignoring the former.

While this Article does not aim to offer a comprehensive set of detailed policy prescriptions, it does briefly explore some of the obvious policy implications of these arguments in Part V. First, many of the post-crisis initiatives to reform the financial system are misguided. Among other things, Dodd-Frank and Basel III propose reducing investor expectations of government bailouts, increasing the issuance of long-term bank debt, and improving transparency. As I describe, these proposals are unlikely to result in the expected benefits, and may indeed be counterproductive to systemic stability. Second, contrary to the efforts of the corporate governance movement, this Article proposes delinking the incentives of managers and shareholders. Bank shareholders have unique incentives to increase risk-taking, particularly during periods of credit expansion. Aligning the incentives of bank managers with shareholders is thus not in the interests of prudential regulation, which seeks to limit bank risktaking. Finally, the realization that market discipline is flawed establishes the need for more aggressive action in other areas, including increasing capital requirements and reducing the size and complexity of the largest financial institutions. Regulators have come to rely heavily on market discipline as a supplementary tool, and so reducing reliance on this third pillar of banking regulation necessarily means bolstering their ability to rein in bank risk in other areas.

II. THE LAW AND ECONOMICS OF MARKET DISCIPLINE

The theory of market discipline in banking is related to the efficient markets hypothesis (8)and generally asserts that depositors (and similarly situated investors) (9) can rein in the risk taken by banks through market based mechanisms. (10) Market discipline is derived from a broader literature, related to the efficient markets hypothesis, which argues that in the absence of transaction costs and informational asymmetries, markets reach efficient outcomes, and that governmental intervention can distort market incentives to reduce risk-taking and lead to less than optimal outcomes. (11) Advocates of this doctrine have argued that measures that increased market discipline would improve the safety and soundness of banks, both by exerting some increased measure of direct discipline, and by providing banking regulators with important market signals on bank risk. (12)

While market discipline is now one of the core paradigms in banking regulation, this was not always the case. In fact, until the 1980s, the basic precepts of this doctrine were considered and then explicitly rejected. This Part provides a brief overview of the theory of market discipline, and how it interrelates with federal deposit insurance and banking panics, before proceeding into a summary of the empirical and theoretical literature examining the efficacy of market discipline prior to the 2007-2008 financial crisis.

A. Federal Deposit Insurance and the Problem of Banking Panics

Banks are typically understood as having several key features that make them unique among market participants. (13) First, banks are primarily in the business of making idiosyncratic investments with high evaluation and monitoring costs, creating potential information asymmetries between banks and their outside investors. (14) Second, banks have a maturity mismatch between their assets and liabilities, insofar as they use short-term liabilities (such as deposits redeemable upon demand) to fund long-term assets (such as loans). (15) Third, banks are funded by an unusually high level of debt, with only a small amount of equity to serve as a buffer against losses on those debt obligations. (16) Collectively, these attributes make banks highly vulnerable to the problem of bank runs. (17)

The high level of debt means that a relatively small credit loss can render a bank insolvent. At the same time, the informational asymmetries inherent in banking mean that depositors do not know whether a particular sign of bank problems (such as long lines of people seeking to withdraw their funds) is an indication that the bank is insolvent. Finally, the maturity mismatch of bank assets and liabilities means a bank does not have sufficient liquid assets to pay off more than a very small fraction of its liabilities at any given time. If a large number of depositors simultaneously seek to withdraw their funds from the same bank, that bank must find new sources of liquidity, and this may entail selling off its loans in a "fire sale" environment. As Diamond and Dybvig famously demonstrated, bank runs can thereby cause even healthy, well-managed, well-capitalized banks to fail, by forcing them to liquidate profitable assets at a loss. (18) In the aftermath of a bank run, it is sometimes difficult to tell whether a bank's failure was because it was already insolvent from credit losses, or its insolvency was only caused by a lack of liquidity.

Because of this dynamic, bank runs can be self-fulfilling prophecies. As Bank of England Governor Sir Mervyn King has said, "it [is] not rational to start a bank run[,] but [it is] rational to participate in one once it has started." (19) Once a bank run has started, it does not matter whether this run is based on economic fundamentals or not, as the liquidity shortfalls created by a bank run can themselves cause insolvency. Depositors are not well positioned to know whether a bank being run upon has a weak or strong investment portfolio, but they do know that those who are last to withdraw their funds will find themselves with the largest losses. (20)

Moreover, bank runs can quickly lead to the problem of contagion, in which a run on one bank causes deteriorating confidence among depositors at other banks, leading to further bank runs. If these runs reach a critical mass, they can cause systemic dislocation and large economic losses, as banks across the system are forced to fire sale illiquid assets at a loss in order to meet increasing redemptions by depositors. In other words, contagion can quickly turn runs on individual banks into system-wide banking panics (21) Such banking panics can lead to enormous costs across the broader economy, as we experienced in the Great Depression. (22)

Federal deposit insurance, which was first introduced in the 1930s, (23) effectively solves the problem of banking panics by providing depositors with a credible source of confidence their funds will be repaid and thus removing any credit risk-related reasons to withdraw their funds from banks. Indeed, the first several decades following the introduction of federal deposit insurance were an era of remarkable and unprecedented financial stability. Bank runs became virtually nonexistent, (24) and the U.S. banking system did not experience a banking panic until 2008. (25) There were also very few bank failures until the 1980s. (26) Perhaps as a result of the success of the U.S. experience, government deposit insurance programs were universally established throughout the developed world. (27)

B. Market Discipline as a Critique of Government Guarantees

Given the broad acceptance today of the theory of market discipline, it is easy to assume that market discipline has always been a core tenet of banking regulatory policy. But the primacy of this doctrine is actually a relatively recent phenomenon, which largely began as a criticism of the distortive effects of government guarantees of bank liabilities. Beginning in the late 1960s, as U.S. banks began to take on increased risk, a growing number of scholars began to criticize federal deposit insurance for eliminating the incentives of depositors to monitor and discipline banks, thus leading to a wholesale mispricing of bank risk. (30) The rise of market discipline paralleled the rise of the "efficient markets hypothesis," which generally asserts that financial prices accurately reflect all publicly available information. (31) Indeed, the theory of market discipline is best understood as a corollary of the efficient markets hypothesis, insofar as one of its core assumptions is that the pricing of banking liabilities reflects all publicly available information about the bank's risk. (32) More broadly, critics of the regulatory regime in place for banks increasingly challenged the prevailing wisdom, which had dominated banking economics since the Great Depression, that banks served a special function, arguing that the unique attributes of banking were a byproduct of the special regulatory treatment of banks rather than something intrinsic to financial intermediation. (33) In this view, the special treatment of banks was itself the problem with banking regulation, with the solution being to adopt the same capital markets-based approach to the regulation of banks that governed other financial actors.

The market discipline critique of federal deposit insurance gained rapid acceptance in the 1980s due in large part to the struggles of commercial banks and particularly the thrift industry. The stagflation of the late 1970s and early 1980s had put heavy competitive and earnings pressure on U.S. depository institutions, and the deregulation of the early 1980s allowed U.S. banks and thrifts to take on much greater risk. (34) The lower profitability and more lenient regulatory oversight that resulted led to a large number of failures of depository institutions, which became known as the savings and loan crisis. (35) The United States had not experienced so many failures since the 1930s. (36)

By the 1990s, the theory of market discipline had come to dominate the banking literature, both in economics (37) and law. (38) As discussed in greater detail below, market discipline was formally introduced into both U.S. and international banking regulation with the enactment of the Federal Deposit Insurance Corporate Improvement Act of 1991 (FDICIA) and the announcement of Basel II, respectively.

Generally speaking, proponents of this doctrine have made two related assertions: first, that depositors and creditors could meaningfully rein in risk at banks by acting in their own self-interest; second, that government guarantees on bank liabilities (39) eliminated the incentives for these investors to provide such market discipline, creating a form of moral hazard. (40) In short, as Calomiris and Kahn wrote in one of the seminal papers on market discipline, in the absence of federal deposit insurance and its distortive effects, investors could discipline risky banks by "'vot[ing] with their feet'"--their "withdrawal of funds is a vote of no-confidence in the activities of the banker." (41) As described below, almost all of this literature has been focused on the market discipline exerted by depositors and senior unsecured creditors of banks.

C. The Pre-Crisis Literature on Market Discipline

Despite its ready acceptance into the mainstream following the aftermath of the savings and loan crisis, the theory of market discipline remained controversial for some time with many critics claiming that improving the conditions for market discipline would not actually reduce bank risk. (42) The question of whether market discipline actually works as hypothesized has subsequently been the subject of extensive empirical and theoretical research, with the analysis focusing on two key questions. First, are bank investors able to accurately monitor changes in bank risk and incorporate those assessments into the bank's security prices? Second, do these actions actually influence the behavior of bank managers in a way that reduces risk? (43)

In summary, the literature generally finds that despite the presence of information asymmetry issues, bank investors do exert market discipline once banks begin to exhibit clear signs of trouble. However, there is a dearth of evidence and significant dispute around the question of whether market discipline actually affects bank risk-taking. This is due in large part to the ex post nature of market discipline in banking, which typically is exerted only after credit losses begin to threaten a bank's solvency, long after risk is actually incurred.

1. Are Investors Able to Monitor Risky Banks?

One of the threshold criticisms of market discipline is the claim that bank investors are not well suited to monitor and act on changes in risk due to the particular characteristics of investors in bank liabilities, (44) the collective action problem facing these investors, who tend to be heterogeneous and small, (45) and the information asymmetry inherent to banks, discussed above. Because many bank investors, particularly retail depositors, are unsophisticated, it has been argued that they are poorly equipped to receive risk-related information about their banks and likely to misinterpret such information because of a lack of financial literacy. (46)

There has been extensive empirical research on this topic, with the vast majority of studies concluding that, despite the information asymmetry problems they face, uninsured depositors do attempt to monitor and discipline risky banks either by withdrawing their funds or by demanding higher interest rates. (47) For example, Billet et al. (1998), (48) Park and Peristiani (1998), (49) Jordan (2000), (50) Goldberg and Hudgins (2001), (51) Calomiris and Wilson (2004), (52) Davenport and McDill (2005), (53) Maechler and McDill (2006), (54) and Shimizu (2009) (55) have found that banks on the verge of failure experience an exodus of uninsured deposits. (56) Their findings are supported by Baer and Brewer (1986), (57) Hannan and Hanweck (1988), (58) Cargill (1989), (59) Ellis and Flannery (1992), (60) Kutner (1992), (61) Cook and Spellman (1994), (62) Brewer and Mondschean (1994), (63) and Hess and Feng (2007), (64) who find that riskier banks pay higher rates on uninsured deposits.

In large part because of the concerns around information asymmetry for depositors, regulators have actively encouraged the issuance of bank subordinated debt with the intention of creating another, perhaps more powerful, source of market discipline. (65) Unlike demand deposits, subordinated debt is not insured, and its investors are typically more sophisticated than depositors. Thus, at least in theory, subordinated debt should provide a more effective form of market discipline than depositor discipline, all else being equal. (66) The empirical literature on subordinated debt discipline generally finds that subordinated debt holders, like uninsured depositors, do attempt to exert market discipline on high-risk banks. (67)

Market discipline exerted by other banks-so-called interbank discipline-has also been highlighted as a potentially strong source of market discipline for a number of reasons. (68) First, interbank loans are typically short duration (often overnight), which allows bank lenders to immediately react to new information by demanding higher yields or refusing to roll over their loans. (69) Second, interbank loans are uninsured and often uncollateralized, providing bank lenders with ample incentive to monitor the risk of their counterparties. (70) Third, it is generally believed that banks are in a better position than other types of investors to analyze the risks of other banks because they themselves well understand the business of banking. (71) Fourth, interbank loans are often utilized by smaller banks, whom often do not issue subordinated debt. (72) Fifth, interbank loan markets (such as repo) are fairly deep and liquid, which allows for more efficient market responses (73) While the empirical literature on interbank discipline is not as well developed as the literature on subordinated debt discipline, it has been consistent in finding that banks do attempt to monitor and enforce market discipline with respect to their exposure to liabilities issued by other banks. (74)

In summary, while there are some empirical studies to the contrary, on the whole, most of the empirical research has found that market discipline may be an effective tool in monitoring and identifying firms that are at risk of failure. (75) It is, however, important to understand how this market discipline is exerted. As Bliss (2004) has noted, market discipline can potentially be either ex post or ex ante. (76) Ex post discipline arises in response to the actions of bank managers, whereas ex ante discipline occurs contemporaneously with the actions of bank managers (and thus incentivizes outcomes consistent with the markets' interests). (77)

It is well understood that the mechanisms by which market discipline in banking is exerted-an increase in the yields demanded by creditors and the withdrawal of funds-are ex post forms of discipline, insofar as they occur after the bank has already taken on risk. (78) Advocates of market discipline argue that such ex post discipline also provides some ex ante discipline, insofar as bank managers may consider the future effects of their decisions to take on greater risk, but acknowledge that any such ex ante effects are indirect and attenuated. (79)

The ex post nature of market discipline is further exacerbated by the fact that such discipline occurs in response to lagging indicators. As is well described in the theoretical and empirical literature, market discipline by depositors, subordinated creditors, and bank creditors generally occurs in response to signs of potential bank default, such as the amount of nonperforming loans, (80) bond rating downgrades, (81) drops in profitability, (82) negative regulatory actions, (83) asset volatility, (84) and other measures that are seen as predictive of impending bank failure. (85) But of course, there is frequently a long lag between the decisions of bank managers to take on risk and the manifestation of those decisions into visible signs of bank distress. As such, even if market discipline is actually exerted by investors, it may not actually impact bank risk-taking. As one commentator has argued, it may be the case that creditors wield market discipline "as soon as a bad realization of the investment becomes apparent ex post, [but] their behavior will not prevent inefficiently high-risk choices by the bank ex ante." (86)

2. Does Market Discipline Affect Bank Risk-Taking?

The question of whether ex post market discipline can affect ex ante bank actions can be phrased another way: Does market discipline directly affect bank risk-taking? (87) Unfortunately, as a number of commentators have noted, the vast majority of the empirical research conducted around market discipline has focused on whether depositors and other investors actually exert market discipline and not on whether this discipline influences bank behavior. For a number of reasons, including the difficulty of observing market influence, there is a relative paucity of research on the question of whether market discipline actually leads to reduced risk-taking by banks. (88)

The limited empirical research asserting that market discipline affects ex ante decision making is largely suppositional, lacking direct evidence of such a cause-and-effect relationship. For example, Maechler and McDill (2006) find that failing banks utilize less uninsured deposits and conclude that depositor discipline affects the availability of bank financing. (89) As they note, these findings do "not provide conclusive evidence on the effectiveness of depositor discipline in reducing banks' risk appetite," but do support the hypothesis that such discipline might affect bank behavior by "effectively constraining] bank managers' behavior." (90) Other studies seeking to address the question of whether market discipline exerted by bank investors actually impacts bank risk have been similarly speculative in showing causation. (91)

In short, at this point there is no direct evidence that ex post market discipline affects the ex ante decisions of bank managers in taking on risk. The handful of studies that have sought to establish a causal relationship between market discipline and reduced risk have generally been limited to showing that market discipline could theoretically lead bank managers to reduce risk, without actually demonstrating that this occurs.

3. Strong Form vs. Weak Form Market Discipline

The question of whether ex post market discipline affects ex ante bank behavior has largely divided advocates of market discipline into two camps, which I refer to herein as "strong form" and "weak form" discipline, as I think this classification helps to understand the theory of market discipline. (86) Advocates of what I call "strong form" market discipline believe that the self-interested actions of bank investors drive optimal ex ante outcomes, and thus assert that the modern banking regulatory regime is mostly unnecessary and counterproductive, displacing the efficient outcomes that would occur in the absence of governmental intervention. (93) Under this view, banking regulation is only justified because it counteracts the moral hazard effects of federal deposit insurance; in the absence of federal deposit insurance and the market distortions it creates, banking regulation would be largely or entirely redundant, as market participants would efficiently monitor and regulate their own interests. Former Federal Reserve Chairman Alan Greenspan neatly summed up strong form market discipline when he stated, "Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation." (94)

Notably and perhaps necessarily, strong form market discipline rejects many of the key assumptions that have been central to banking regulation since the Great Depression. It has been accompanied by a good deal of self-described historical revisionism, particularly with respect to the likelihood, costs, and causes of banking panics. Some advocates of this view have challenged the previously held wisdom that competition in banking had been a key cause of pre-New Deal financial instability. (95)

Others have argued that the costs of banking panics were vastly overstated, (96) and that previous experiences with "free banking"--banking systems in which there was no federal deposit insurance and minimal regulation--were, contrary to conventional wisdom, quite successful. (97) A few have gone so far as to argue that banking panics--the raison d'etre of federal deposit insurance and the modern banking regulatory regime--are a historical anachronism, rendered obsolete today by financial market innovations and the provision of liquidity by the Federal Reserve. (98)

Like strong form market discipline, weak form discipline is based on the assumption that interested bank investors do provide an important monitoring function, and that this monitoring is inhibited by the moral hazard problems associated with federal deposit insurance provided to traditional banks. But the weak form view disagrees with the notion that ex post market discipline actually impacts ex ante bank risk-taking, and it also rejects the argument that market discipline is better than government regulation at actually constraining risk. (99)

Weak form market discipline therefore calls for keeping federal deposit insurance in place and adopting market discipline as a supplementary prudential tool, meant to provide under-resourced regulators with important market signals (price and liquidity changes) on bank risk. (100) As one leading expert on market discipline has stated, "[i]t seems likely that investors have a comparative advantage in monitoring, while supervisors have a comparative advantage in influencing. If this is correct, then market price signals should be used primarily to assure that supervisors act more promptly when confronted with a firm that appears troubled." (101) In other words, weak form market discipline is predicated on the idea that investors in bank-issued liabilities can provide information, primarily through pricing and liquidity changes, that can "act as an early warning signal" of any problems at banks. (102)

III. The Failure of Market Discipline

The financial system from 2001-2007 was perhaps ideally situated for the success of market discipline. As this Part describes in greater detail, by the early 2000s, the conditions for both weak form and strong form market discipline to succeed had been firmly established. In traditional banking, a number of important regulatory developments intended to improve the conditions for weak form market discipline were implemented, which should have created new and robust sources of market discipline and armed investors with better and more frequently updated information about bank risk.

At the same time, the rise of shadow banking--credit intermediation that falls outside of the traditional banking regulatory umbrella, and thus does not have either the prudential oversight or governmental safety nets associated with traditional banking--also established arguably the ideal conditions for strong form market discipline. Because shadow banking does not have formal government backstops, the moral hazard problem that presents itself for govemmentally insured deposits did not exist. (103)

Moreover, shadow banking was distinct from traditional banking in a number of ways that should have ameliorated the information asymmetry issues that were understood to have been a barrier to the effectiveness of market discipline in traditional banking. The sheer scale of shadow banking--which reached a peak of $20 trillion in global liabilities, a level that significantly exceeded the size of the traditional banking system--provided a broad-scale test of strong form discipline. (104)

In short, the decade preceding the recent financial crisis was a prime laboratory for evaluating the effectiveness of both weak and strong form market discipline. And yet what we experienced was a comprehensive and nearly total failure of market discipline, as detailed in this Part. Contrary to the predictions made by advocates of strong form market discipline, investors failed to rein in bank risk-taking in the period preceding the financial crisis. More curiously and problematically, neither strong nor weak form market discipline reacted to increasing bank risk until the financial crisis was already underway, as this Part describes in some detail. Whether it was bank debt, interbank liabilities, or asset-backed securities, neither the pricing nor liquidity of these instruments reacted in a way that would have indicated higher levels of risk until after July 2007.

A. The Implementation of Weak Form Market Discipline

Following the implosion of the thrift industry in the 1980s, which most commentators attributed at least in part to major regulatory failures, (105) policymakers and regulators, both in the United States and abroad, were quite receptive to the view that market discipline could complement and improve bank oversight. They responded by explicitly adopting measures meant to improve and facilitate the market discipline of banks. Weak form market discipline also came into favor because of the increasing size and complexity of the largest banks, which were seen as too large and unwieldy for regulators to effectively supervise without assistance. (106)

Market discipline was first formally implemented into U.S. banking regulation with the passage of the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). (107) FDICIA implemented a number of key reforms to federal deposit insurance that aspired to enhance market discipline, including prompt corrective action, risk-based deposit insurance premiums, (109) and least-cost resolution. (110) Risk-based premiums would create a regulatory analogue to market discipline, it was argued, by imposing a higher cost of funding on riskier banks, just as private creditors would do. Prompt corrective action and least-cost resolution, which removed regulatory discretion to forbear and extend the federal safety net, would directly foster market discipline by creating a large class of uninsured depositors and other uninsured creditors with no reasonable expectation of being rescued in the event of failure. These investors would have ample incentives to actively monitor and discipline the banks in which they invested. (111)

FDICIA's efforts to promote market discipline were subsequently bolstered by the Basel Committee on Bank Supervision's 2001 release of the New Basel Capital Accord, more commonly known as Basel II (because it updated the original 1988 Basel Capital Accord). Basel II, which set forth international standards as to the prudential regulation of financial institutions, explicitly incorporated market discipline as one of its three "pillars" of banking supervision. (112) The FDICIA primarily sought to promote market discipline by creating new classes of uninsured depositors and unsecured creditors who would have the incentives to monitor their investments and take action against riskier banks. Basel II aimed to increase the scope, frequency, and quality of bank disclosures about risk, in order to better equip depositors and senior creditors with information with which to wield market discipline. (113) While Basel II was never fully implemented in the United States, (114) federal banking regulators incorporated the market discipline pillar of Basel II. This improved existing SEC disclosure requirements for banks (and bank holding companies) with publicly traded securities by demanding that they provide more and better information, such as loan-level data and information on off-balance sheet risk exposures, in their regulatory Reports of Condition and Income. (115)

In summary, an increasing emphasis on market discipline by bank regulators and scholars, coupled with several notable legislative initiatives to improve the conditions for market discipline, meant that the conditions for the success of weak form discipline were as good as they had ever been. Policymakers, regulators, and academics alike emphasized the importance of encouraging or compelling traditional banks to issue uninsured liabilities with the goal of creating new sources of market discipline. They also emphasized the importance of encouraging or compelling banks to release more detailed, frequent, and usable disclosures, so as to help investors make more accurate determinations of bank risk. As importantly, regulators were increasingly open to using such data to help guide their supervision of banks. (116)

B. Shadow Banking and the Reemergence of Strong Form Discipline

At the same time that weak form discipline was being broadly implemented for traditional banks, a set of parallel developments in the capital markets--the rise of the so-called "shadow banking" system--were creating fertile conditions for strong form discipline.

The term "shadow banking" was coined by Pacific Investment Management Company, LLC ("PIMCO") Managing Director and economist Paul McCulley as a term to describe the enormous amount of credit intermediation occurring outside of the balance sheets of regulated depository institutions. (117) Since that time, there has been a large and growing literature attempting to describe the theoretical and practical underpinnings of the shadow banking system. (118) As with traditional banking, (119) shadow banking is understood as performing maturity and liquidity transformation by utilizing short-term liquid liabilities (similar to demand deposits) to invest in long-term illiquid assets (such as loans). (120) Thus, shadow banking creates additional sources of funding for borrowers and offers investors alternatives to traditional bank deposits.

While shadow banking resembles traditional banking at a high level, there are some important differences that make shadow banking a much better environment for market discipline. First, because shadow banking utilizes a complex structure of capital markets funding, rather than deposits, to finance its credit intermediation, it is not subject to the robust governmental intervention that accompanies traditional banking. Unlike traditional banking, shadow banking does not have formal government safety nets or strong prudential oversight by government regulators. Second, there are fairly profound differences between the typical investor in the deposits issued by traditional banks and the typical investor in shadow banking liabilities, and this has important implications for the information asymmetry issues discussed above. Finally, shadow banking has a number of delegated monitors in place, whose role is specifically to monitor shadow banking risk. I discuss each of these differences below.

1. Limited Government Intervention in Shadow Banking

Shadow banking utilizes a variety of capital market conduits and instruments, particularly money market mutual funds, short-term repurchase agreements, asset-backed commercial paper, and asset-backed securitization. (121) Like traditional banking, shadow banking uses short term, high-quality, liquid liabilities to fund long-term, illiquid loans.

But whereas traditional banking does this all '"under one roof,'" shadow banking performs this intermediation "through a daisy-chain of non-bank financial intermediaries in a multi step process." (123)

So, for example, when we think of traditional banking, we think of a loan being held to term by the originating bank, with the funding for this loan coming from the bank's deposits. But in shadow banking, the originator of a loan (124) sells it off to a bankruptcy-remote securitization conduit (typically either a special-purchase vehicle ("SPV") or a structured investment vehicle ("SIV")), which pools a number of other loans and sells off securities representing the cash flows from the loan pool. (125) The origination and securitization of these loans is financed predominantly through short-term funding coming from the issuance of asset-backed securities ("ABS"), asset-backed commercial paper ("ABCP"), short-term repurchase agreements ("repos"), and similar debt or structured credit instruments. (126) These debt instruments are purchased by money market mutual funds ("MMFs"), bond funds, and other entities, including other securitization conduits that then issue new debt obligations based on the cash flows from these liabilities. The end effect is functionally the same--long-term loan assets funded by short-term liquid liabilities--but shadow banking utilizes a potpourri of capital market structures to conduct this intermediation.

Because shadow banking does not directly involve bank deposits, it lacks the explicit governmental support provided to traditional banks. (128) While some shadow banking liabilities are sponsored by or held by traditional banks or bank holding companies, these liabilities, unlike bank deposits, are not backed by government deposit insurance, and they do not privilege their issuers with access to public sources of liquidity, such as the Federal Reserve's discount window for depository institutions. (129)

The lack of government guarantees in shadow banking also means that shadow banks are not subject to the stringent prudential regulation that is in place for traditional banks. Prudential regulation in the United States, prior to the financial crisis, historically covered traditional banks, (130) those that take demand deposits and use them to fund longer-term investments (such as loans). (131) Most of the credit intermediation that occurs in shadow banking involves entities that were unconnected to the balance sheets of traditional banks, including investment banks, broker-dealers, insurance companies, money market mutual funds, hedge funds, and special purpose entities sponsored by bank holding companies. As a result, at least up until the 2007-2008 financial crisis, the credit intermediation performed by these firms fell outside the regulatory umbrella that governs traditional banks. (133) While these institutions were usually supervised by some type of financial regulator, such as the Securities and Exchange Commission or a state insurance commissioner, they were generally not subject to the strict prudential oversight that is the hallmark of banking regulation. (134)

2. Shadow Banking Investors Are Institutional, Not Retail

Another important difference between traditional banks and shadow banks lies in who predominantly funds their activities. Investors in shadow banking are universally large, sophisticated financial institutions with access to detailed information about the risk characteristics of their investments and counterparties. This contrasts with traditional bank depositors, who are typically less sophisticated retail investors who lack both the capacity and the information to accurately assess risk. As such, these differences have important implications for the information asymmetry issues that typically are thought to plague banking.

Much as with traditional banking, intermediation in shadow banking is characterized by information asymmetries between insiders and outside investors. (135) For example, asset-backed securitization, which is at the heart of the shadow banking system, involves a series of information asymmetries at each stage of the intermediation process. (136) Similarly, the asset-backed commercial paper market has steep "information asymmetries between investors and asset managers." (137) As discussed previously, these information asymmetries present a central problem for banking regulation, both because they are a critical factor in causing bank runs, and because they are thought to be impediments for the effective operation of market discipline.

That being said, the characteristics of shadow banking are perhaps ideal for ameliorating these informational issues. (138) Investors in shadow banking liabilities enjoy access to detailed risk-related information, which is much better than the publicly available information depositors rely upon to discipline traditional banks. (139) Moreover, because these investors are themselves large financial institutions, such as commercial banks, (140) investment banks, hedge funds, pension funds, and money market mutual funds, they have the capacity to efficiently process and interpret this information, certainly much more so than the average retail depositor.

3. Delegated Monitors to Ameliorate Information Asymmetry Issues

Shadow banking also has in place a number of important mechanisms that, at least in theory, should provide strong market-based risk assessments and further assuage the informational concerns of investors. In particular, there are a number of well-situated monitors who possess both the interest and wherewithal to provide accurate risk assessments of shadow banking liabilities. (141) Three such sets of monitors are worth mentioning.

First, there are the sponsors of asset-backed securitization conduits, typically investment banks, such as Goldman Sachs, or bank holding companies, such as Citigroup. These firms provide a number of different types of guarantees to ABS and ABCP investors, all of which should give them incentives to closely monitor the credit quality of the assets in the pool. ABS conduit sponsors typically provide representations and warranties as to the quality of the assets collateralizing these securities. (142) They also often purchase the most subordinated securities, ensuring that they will take the first loss on any asset degradation and thus providing a buffer against losses for other investors. (143) Moreover, even though ABS conduits are technically independent, off-balance sheet entities, their sponsors often provide implicit "reputational" guarantees on losses. (144) ABCP sponsors usually provide full or partial support to their conduits, which includes an arrangement with a bank (often the sponsor itself) to provide liquidity to the conduit as necessary, and, most importantly, a guarantee to cover credit losses on the underlying assets (either all losses, in the case of fully supported ABCP conduits, or losses in excess of a prespecified amount, in the case of partially supported ABCP conduits). (145) Because of these factors, securitization sponsors have ample incentives to ensure that their conduits do not suffer large credit losses, and they possess the necessary information to effectively monitor these conduits. (146)

Second are the third-party providers of credit enhancement on shadow banking liabilities, the bond insurers, and credit default swap counterparties. Because bond insurers and credit default swap (CDS) counterparties agree to cover credit losses on shadow banking obligations in the event of defaults or similar events, they have significant incentives to monitor the credit risk underlying these instruments. (147) Moreover, prior to the financial crisis, these guarantees were often critical for attracting investors as they were used to enhance the credit ratings provided to a particular security, and because some investors would only invest in securities that carried such credit enhancements. (148)

Both bond insurers and CDS counterparties provide an important monitoring function for shadow banking liabilities. Bond insurers have access to considerable amounts of information about the securities they are insuring--arguably all the relevant information they need. (149) Additionally, they have developed significant expertise in assessing the credit risk associated with bonds and structured financial products (such as ABS and CDOs), as this has been their core business for several decades. (150) While CDS counterparties do not enjoy the same access to inside information as bond insurers, they are universally large and sophisticated financial institutions, such as banks, securities firms, hedge funds, and bond insurers. (151) The development of the CDS market in particular was heralded as an important means of improving market discipline since it provides a clear external measure of risk. (152)

Collectively, bond insurers and CDS counterparties have a large footprint on the shadow banking system. Bond insurers guaranteed more than $1 trillion in ABS (including over $700 trillion in U.S. ABS) and some $300 billion in CDOs as of September 30, 2007. (153) CDS reached a peak of $58.2 trillion in notional value (the total amount guaranteed against) and $2.02 trillion in gross value (the outstanding mark-to-market value of CDS contracts) at the end of 2007. (154) At least in theory, the self-interest and expertise of bond insurers and CDS counterparties should have served an important market disciplining role on the ABS, CDOs, and other liabilities that funded shadow banking intermediation.

Third are the credit rating agencies, who are tasked with providing alphabetically-based credit quality assessments for fixed income obligations, including most of the liabilities that were central to funding shadow banking intermediation. Credit rating agencies are paid by the issuer of the securities they rate, (155) and utilize a detailed methodology to rate structured products like ABS and CDOs, which involves looking at a number of attributes at both the loan level, including loan-to-value ratio, borrower credit score, borrower debt-to-income ratio, originator quality, loan characteristics (such as interest-only or adjustable-rate), and documentation status, to name just a few, and at the pool level, looking at external credit support (bond insurance and CDS as described above) and internal credit support (how much subordinated debt and equity supports the top tranches). (156) After providing an initial credit rating, the rating agencies then continue to monitor the securities they rated on an ongoing basis to determine whether downgrades are appropriate. (157)

Rating agencies have access to all of the relevant risk-related information about the securities they rate, and have developed significant amounts of expertise in doing so given that providing credit ratings is and has been their core business for many decades. Prior to the financial crisis, the credit ratings provided by these institutions were a critical part of the shadow banking systems, as investors largely relied upon AAA ratings as a proxy for safety. (158)

In the aggregate, shadow banking serves the key credit, maturity, and liquidity transformation functions of banking, but without the regulatory encumbrances or access to governmental safety nets (particularly central bank liquidity and governmental deposit insurance) that accompany traditional banks. This structure leaves shadow banking vulnerable to the runs and panics that federal deposit insurance is meant to prevent. However, it should also remove any moral hazard concerns, as holders of shadow banking liabilities are uninsured against loss and thus have ample incentives to exercise market discipline. (159) Moreover, shadow banking should be far better equipped than traditional banking to deal with informational asymmetry, both because its investors are much more sophisticated than retail depositors, and because shadow banking developed a number of mechanisms intended specifically to address these information issues.

C. The Failure of Markets to Signal Excessive Risk

Despite the presence of conditions that may be described as close to ideal, market discipline failed to prevent the financial crisis. Heightened market discipline in both traditional banking and shadow banking did not stop firms from building up historically high levels of credit and liquidity risk. (160) As the United Kingdom's Financial Services Authority (FSA) concluded in its review of the financial crisis, "A reasonable conclusion is that market discipline expressed via market prices cannot be expected to play a major role in constraining bank risk-taking, and that the primary constraint needs to come from regulation and supervision." (161)

But more troublingly, bank investors failed to even respond to heightened bank risk until it was too late. (162) While investors clearly reacted to the systemic problems that arose beginning with the subprime liquidity crisis in July 2007, they failed to provide any price signals or other indicia of heightened risk prior to that time, even as there had been increasing evidence of that risk prior to July 2007. (163) This was true across a wide array of markets and instruments, as I describe below.

It was not until July 2007, following the credit ratings downgrade of over 1000 subprime-related securities by the rating agencies Moody's and Standards & Poor's, (164) that market discipline began to operate as theory would have predicted, where banks perceived as having higher risk were punished more severely than banks perceived as having less risk, as discussed in this Section.

The failure of bank investors to respond to elevated bank risk was at odds with the core assumption of both weak and strong form market discipline--that market discipline can identify risky banks through price and liquidity signals. This Part outlines the failures of market discipline in identifying banking and shadow banking risk prior to the crisis, focusing on a series of relevant indicators.

1. Liabilities of Individual Banks Failed to Timely Identify Risk

Several studies have looked at the market discipline exerted by investors in the non-guaranteed liabilities of both banks and investment banks. Stephanou (2010) looked at the market discipline exerted on various liabilities of major shadow banks from 2006 to 2009 and found that none of the key market metrics that should have theoretically provided signals on the risk of these financial firms showed any indications of elevated risk until August 2007 or later--long after these firms had actually taken on this risk. (165)

Stephanou's findings are consistent with the observations of Lee, Miller, and Yeager (2013), who looked at the yields on subordinated debt issues from 2002-2007 and compared those to a number of commonly used risk metrics (such as the ratio of non-performing loans to total assets, the total leverage ratio, and ratio of real estate investments to total assets). (166) Lee, Miller, and Yeager did not find a correlation between subordinated debt yields and higher risk, and thus concluded that "[m]arket participants rewarded good performance but did not punish increased risk. Overall, these results do not show strong evidence of market discipline of banks during the period leading up to the financial crisis." (167) They are also supported by the findings of the United Kingdom's FSA, which looked at CDS prices for sixteen prominent U.S. and European financial firms and found that these prices "did not provide forewarning of the scale of problems ahead ... [and instead] suggested that risks were at historically low not historically high levels." (168)

These findings are bolstered by Figures 1-6 below, which illustrate the CDS prices, senior debt yields, and subordinated debt yields from 2004 to late 2008 for Citigroup, a bank holding company that also had significant investment banking activities, and Merrill Lynch, an investment bank. (169) Both of these firms had accumulated very high levels of mortgage-related risk and consequently suffered major losses. (170) These charts, which are representative of the data for all large commercial and investment banks, (171) demonstrate quite clearly that the investors in these individual bank liabilities did not react until after July 2007, and often not until quite later.

What is particularly striking about these findings, and the findings of Stephanou and Lee, Miller, and Yeager, is the clear evidence that these key market-based price signals, which were generally understood as highly reliable quantitative indicators of insolvency risk, (172) failed to provide any indication of higher risk during the period preceding the financial crisis. Even as financial firms took on high levels of exposure to U.S. mortgages, U.S. households became historically overleveraged, and evidence of a housing bubble became clear, the major price signals that should have alerted regulators to the existence of potential problems were nonreactive, as the below charts clearly illustrate.

2. Interbank Borrowing Rates Failed to Timely Signal Systemic Risk

Market discipline also failed in identifying systemic risk. A key market indicator of systemic (as opposed to bank-specific) risk is the general rate at which banks are willing to lend to one another. The term LLBOR-OIS spread, which represents the difference between the London interbank offer rate (LIBOR)--the rate at which banks are willing to lend to one another--and the overnight indexed swap (OIS) rate--the rate on a derivative of the overnight risk-free rate, is considered a leading measure of bank health, as it neatly captures banks' perceptions of the credit risk of lending to other banks. (173) As discussed previously in Part II, interbank discipline is thought to be an important and particularly powerful source of market discipline, and the interbank borrowing rate, captured by LIBOR, is a key metric for interbank discipline. (174) As former Federal Reserve Chairman Alan Greenspan has said, "LIBOR-OIS remains a barometer of fears of bank insolvency." (175)

LIBOR-OIS is also a critical metric for shadow banking, insofar as it was typically used as the reference rate for virtually all subprime mortgages outstanding in the United States. (176) Additionally, LIBOR is used as a reference rate for a number of other financial products critical to the shadow banking system, including more than $10 trillion in corporate loans, floating rate notes, and adjustable rate mortgages, and some $350 trillion in notional value of interest rate swaps. (177)

As with the more bank-specific sources of market discipline (CDS, senior debt, subordinated debt) described above, LIBOR-OIS did not provide any indications of credit risk until after the onset of the subprime related financial markets turmoil of July 2007, as Figure 7 illustrates. 78

LIBOR-OIS was not the only interbank lending signal that followed this pattern of unresponsiveness prior to the crisis, followed by extreme volatility after the onset of the crisis. For example, as Gorton and Metrick (2009) point out, the haircuts on interbank repurchase agreement ("repo") lending (short-term lending collateralized by assets) did not indicate any systemic risk until after July 2007, with most of the volatility in these haircuts coming in 2008. (179)

3. Market Pricing of ABS Failed to Timely Signal Systemic Risk

The ABX.HE indices, which measure CDS perceptions of risk associated with a representative series of private-label (180) mortgage-backed securities, were another important measure of market discipline that should have provided timely and accurate market signals of risk associated with the securities at the heart of the shadow banking system. (181) ABX.HE price information was widely used by the financial markets to gauge and hedge risk related to subprime mortgage backed securities ("MBS"), which were at the heart of the shadow banking system during the past decade. (182) For example, UBS, Citigroup, and Morgan Stanley all used ABX.HE indices to justify their write-downs of subprime-related holdings, and Goldman Sachs utilized ABX.HE prices in setting the CDO prices it quoted when demanding collateral payments from AIG. (183)

As with LIBOR, these ABX.HE price indices did not provide any meaningful signals of credit risk up until 2007. The price indices for the investment-grade (AAA or AA) rate securities in ABX.HE 06-01, which is the oldest ABX vintage and consists of asset-backed securitization deals issued in the second half of 2005, traded near full value ("par") up until July 2007, at which point these securities experienced high price volatility. (184) So for example, as of June 2007, the AAA tranches of ABX.HE 06-01 and ABX.HE 06-02 (the next oldest ABX vintage, which consisted of deals issued in the first half of 2006) traded at close to 100 (par) in June 2007, whereas they declined significantly to trade at 92 and 69, respectively, by June 2008. (185)

ABX price signals were consistent with other market-based measures of risk, insofar as they did not indicate any concerns about credit risk (186) until 2007, with the investment-grade tranches not showing any price movements until the subprime mortgage crisis of July 2007.

4. Clear Evidence of Bank Risk Prior to July 2007

These market signals failed to respond to heightened bank risk until after July 2007, but there were some clear and publicly available signs of such risk, both at particular institutions and across the financial system, which should have been of great concern to investors in bank and shadow bank liabilities. By 2005, home sales had begun to drop. (187) By 2006, housing prices had started to decline after years of tremendous growth. (188)

And by early 2007, the number of subprime mortgage originations plummeted, (189) even as subprime delinquency rates began to soar.

This led to severe issues in the subprime mortgage lending industry. In December 2006, Ownit Mortgage Solutions, the eleventh largest subprime lender, collapsed. (191) In January 2007, Mortgage Lenders Network, another large subprime lender, announced that it would no longer accept applications for new loans; it filed for bankruptcy in February. (192) Also in February 2007, New Century, one of the largest subprime lenders, reported larger-than-expected losses, and HSBC, the largest subprime lender in the United States, "announced a $1.8 billion increase in its quarterly provision for losses." (193) New Century filed for bankruptcy two months later, in April 2007, (194) and HSBC ultimately incurred some $60 billion in losses from bad loans originated in North America. (195) These were the first, but not last, in a long string of failures of subprime lenders. Ownit, Mortgage Lenders Network, and New Century, like most other subprime lenders, had close relationships with major financial firms such as Merrill Lynch, Lehman Brothers, and Citigroup, which typically financed the loans originated by these non-bank lenders through warehouse loans, and in return received the right to buy and securitize the loans being originated. (196) The fact that these subprime lenders began to fail en masse should have been reflected in higher risk premia being attributed to the financial firms that bought and securitized mortgages originated by these lenders.

Problems with residential mortgages, particularly subprime mortgages, led to severe turmoil in the markets in ABS and collateralized debt obligations ("CDO") by the summer of 2007. In June 2007, Bear Steams suspended redemptions from a hedge fund it had sponsored, which had invested heavily in subprime CDOs, and then followed that up with a $3.2 billion bailout of the fund. These actions were insufficient to prevent this fund and another Bear-sponsored hedge fund focusing on subprime-related investments from failing in July 2007.

Indeed, while market discipline failed to warn regulators of the large buildup of risk that was occurring at individual financial firms and across the broader banking system, there were a number of individuals who did precisely that. Robert Shiller, who has since won the Nobel Prize in Economics for his work on asset bubbles and irrational exuberance, repeatedly stated that housing prices were unsustainably high prior to 2007. (199) Economist Dean Baker argued that a housing bubble emerged as early as 2002. (200) Beginning in early 2006, hedge fund manager John Paulson began to bet heavily against mortgage-related financial instruments, convinced that rating agencies and other investors had underestimated the risk of these securities. (201) These and many other observers identified the high levels of risk being accrued in the financial system and at specific firms. In other words, there was sufficient publicly available information to recognize heightened risk--and indeed, many market observers and participants did recognize this risk--but this was not reflected in the pricing or liquidity of bank-related instruments, as the theory of market discipline would have predicted.
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Title Annotation:Abstract through III. The Failure of Market Discipline, p. 1421-1468
Author:Min, David
Publication:Washington University Law Review
Date:Sep 1, 2015
Words:10537
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