In order to counteract this loss of market discipline, governments introduce regulations aimed at preventing bank managers from taking excessive risk.
Today market discipline is introduced into the Basel II Capital Accord as a pillar of prudential banking regulation.
Later studies, though, when including some of the previously missing key aspects into the empirical analysis, supported the existence and significance of such a natural control mechanism unambiguously.
This is precisely why regulators support the idea of including market discipline as another channel to complement regulatory policies.
We can promulgate countless new regulations governing every aspect of bank behaviour and hire thousands of additional examiners to enforce them.
This approach would undercut the benefits sought through deregulation, would favour the unregulated at the expense of the regulated, and would ultimately fail.
The FDIC much prefers the other alternative: seeking ways to impose a greater degree of marketplace discipline on the system to replace outmoded government controls".
Deposit insurance in the U.S. was instituted in 1934 to restore depositor trust into the financial markets following the devastation of the Great Depression.
Concerning market discipline, one can easily say that mispriced deposit insurance distorts the incentives of depositors to monitor bank risk taking activities.