The financial turmoil that we have been living with since August 2007 has left central banks, regulators, politicians, and economists with two big, overriding questions: How do we best get out of the crisis and how should banks be regulated and markets organized to avoid such crises in the future. This paper deals with the second question. Specifically, the paper deals with the third pillar of Bank supervision under Basel II, namely market discipline. The idea of this pillar, as summarized by Emmons, Gilbert, and Vaughan (2001), is for supervisors and regulators to make use of information about the financial health of banks that is contained in securities prices. In particular, as explained by Emmons et al: “The recent market discipline discussion centers on proposals to require some banks to issue a standardized form of subordinated debt.” Flannery (1998) discusses this more broadly and reviews the evidence on the effectiveness of using market information in prudential supervision. My proposal here is that the market discipline approach could usefully look for information about banks’ financial health outside of the securities markets. The market that I would suggest is especially valuable is the market for liquidity. This is motivated by the simple observation that the financial crisis of 07/08 has manifested itself in -- and rippled outwards from -- this market. Below, I briefly outline some features of the market for liquidity during the crisis and draw some comparisons to times of normalcy, before turning to my proposal. Some of what we see during the crisis period arguably can be explained by imperfections such as adverse selection, leading to credit rationing and relatively high unsecured rates. There are also imperfections present in the market for liquidity during times of normalcy (see, e.g., Bindseil, Nyborg, and Strebulaev~(2008)). Thus, as new regulation gets shaped in the wake of the crisis, it would appear that it is valuable to put measures in place to control these imperfections so that they do not flare up again. The suggestions I make in this paper are motivated by this concern.
