Publication

This paper argues that accounting for the behavior of firms and markets is important for understanding the extent and form and the effectiveness and efficiency of government regulation, particularly in economic policy. The authors examine the US banking sector and its regulation in the 1990s to gain insights on how studies along these lines could be constructed. They focus on market discipline, the main alternative driving force to government regulation and, in particular, the effect of bank capital on banks' borrowing costs. They find that while better capitalized banks have experienced lower borrowing costs, competitive pressure cannot fully counter the freeriding of "unhealthy" banks on a well-capitalized banking sector. These results show that recent US and international (Basel Accord) regulatory reform efforts, which are designed to increase transparency and enhance competition in the banking sector, can be interpreted as an effort to align market forces and regulation in ways that minimize the need for costly government enforcement or bailouts.