Market Discipline and Supervisory Discretion in Banking: Reinforcing or Conflicting Pillars of Basel II?

This paper examines the market-discipline and supervisory-process "pillars" of the Basel II framework. It reviews the key features of these Basel II pillars and discusses and evaluates associated conceptual issues in relation to theoretical predictions and empirical findings in the academic literature. One conclusion is that while the market-discipline pillar is for many nations a potentially useful first step toward improving bank information disclosure, this pillar of Basel II falls short of promoting effective market monitoring by private investors or encouraging the utilization of market signals by both investors and bank regulators. A second conclusion is that the Basel II supervisory-process pillar is completely misguided in its reliance on regulatory discretion, so that implementation of this pillar could potentially have counterproductive safety-and-soundness impacts. Thus, the market-discipline pillar does not go far enough in the direction suggested by academic research, and the supervisory-process pillar actually goes in the wrong direction.