# **I. Introduction**

Despite significant upgrading of bank regulations and supervisory capacity and expertise, there has been little evident improvement in bank failure experience worldwide over the past decade. In addition, cross-country evidence suggests that systems that are overregulated by discretionary official supervisors – ostensibly in the interests of prudence – underperform along a number of dimensions. Perhaps most interestingly, an approach based on strengthening official supervision was found at best to have no significant effect on the development of the financial sector; at worst, except in the most institutionally advanced countries, the effect went the other way (increased supervisory powers associated with less financial sector development). Instead, evidence from a crosscountry survey suggests that banking systems work better where market discipline is fostered by strict accounting and auditing rules, use of international rating agencies by banks, and avoidance of deposit insurance (Barth, Caprio and Levine, 2003).

But how much reliance can one place on market forces where the liquidity, transparency and other underlying characteristics of markets are deficient? Specifically, which elements of market discipline work better in immature environments? Most practitioners think that, as markets plainly do not function well in low-income countries, then it must be the case that market discipline also does not work, and that therefore these countries need to rely more heavily on capital and bank supervision, the two pillars stressed in the approach of the Basel Committee. Is this presumption correct?

This paper reviews the different channels of market discipline, discussing how they work, what the policy and institutional prerequisites are, and outlining existing empirical evidence. New data on the changing degree to which these pre-requisites are in place are presented. Using this data and proxies for the degree of banking vulnerability, we will provide some evidence on the presence of prerequisites for the different flavors in different countries and on their possible effectiveness. However market discipline does function, empirical evidence indicates that it does a better job compared with reliance unofficial supervision. While attempts to improve the latter no doubt should and will continue, there is much to be said in favor of building on strengths. Accordingly, the last section of the paper addresses policy considerations regarding what can be done to improve the functioning of market discipline.

To summarize our findings, there is no systematic tendency for low-income countries to lack the pre-requisites for market discipline. Offsetting factors to the weaker market and formal information infrastructures are (i) the less complex character of banking business in low-income countries; (ii) the growing internationalization of these markets through the presence of foreign banks, and through international trading of the debt and equity of locally-controlled non-government banks; and (iii) the smaller size of the business and financial community. On the other hand, continuing dominance by public sector banks in some countries limits the likely development of market monitoring, clearly a cause for concern, given the disappointing record of governments around the world as monitors of their self-owned banks.