What does it take to make for better market discipline? Consider the four sources of market discipline for banking, noted above: depositors, debt holders, outside equity holders, and information specialists. First, all of them require accurate and timely information to do the best possible job. This means that regulations or listing requirements that necessitate prompt and thorough disclosure of key information relevant to determining bank performance clearly are to be encouraged. What types of information most need to be disclosed, beyond the standard balance sheet and income statement data?

Certainly there is a case to be made that information on the state of a bank’s loan portfolio, and more broadly the credit risk that it has, would be useful for creditors, shareholders, and competitors. Some voluntary disclosure is valuable to banks, both lowering their cost of funds and the volatility of their equity price (Baumann and Nier, 2003). However, there is a clear externality – individual banks are not rewarded for reducing the volatility or funding costs of their competitors – and therefore will not disclose sufficiently credit risk information. If banks were forced to mark their portfolios to market, reporting requirements would be far easier. The absence of this practice – due no doubt to its difficulty, and the related nontradeability of much bank debt -- means that a significant amount of information pertaining to credit, market, and operational risks of banks is required in order to make a reasonable estimate of their health.

One piece of critical information that does not get adequately disclosed (and which would greatly benefit both share and debt holders of banks) is the compensation structure of bank management. The market really needs to be able to understand the extent to which it is risktaking or prudence that is being rewarded. Banks and other firms surely will resist such disclosure, but compensation structures should be factoring into either minimum capital requirements and/or the price charged by the market for outside funding.

As became clear in recent scandals in the United States, it is important that information specialists, such as rating agencies and auditors, are acting at arm's length from the clients whose information they are certifying. In addition to occasionally discussed proposals to make these actors liable for their opinions, it is possible for a regulatory body at the very least to publish their track records, such as the number of times that a client receiving a favorable view from the agency in question has subsequently, within some short time period, developed problems. There is a difference of opinion as to whether these agencies should have their activities restricted, e.g. preventing accounting firms who audit a company from picking up other consulting business. But what needs to be disclosed is not only where such relationships exist, but also the compensation structure for the officers of the accounting firm. This needs to include not just the level of compensation, but importantly the formula that determines it. Such a disclosure would have flagged serious incentive problems at Arthur Andersen, the auditor of Enron and other failed companies. It would also likely help augment market discipline from information specialists.

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