fall if a bank becomes distressed. Equity holders are sensitive to the potential for _upside_ as well as downside. Large depositors, bondholders and outside equity holders, while they may be few, are _potentially many_ . In contrast, approved rating agencies, and to a lesser extent auditing firms, are typically a small and relatively closed group.

For economies with advanced financial systems the argument for market discipline is especially one driven by the increased complexity of finance. In these economies (according to research findings) neither regulators nor the market have the monopoly of wisdom.<sup>2</sup> Market forces can help improve discipline in the banking system by helping to _monitor_ the conduct and condition of the banks (Flannery, 2001). The complexity argument is also relevant for developing countries: even if their financial systems are simpler, nevertheless supervisory capacity is also more limited and the relative effectiveness of risk-assessment by supervisors may be weaker. If so, having market participants help in the monitoring function is even more important.

But market discipline goes beyond monitoring and turns it into discipline by bringing _influence_ to bear directly or indirectly on bank behavior. The direct influence come by altering the _incentives_ for bank insiders, especially by increasing the cost of their funding. Even in the US, however, the indications are that such direct incentive effects are not sufficient to fully correct for excessive risk-taking (Bliss and Flannery, 2001). The indirect mechanism comes by the way in which market behavior serves to _signal_ the results of monitoring to official regulators through its effect on asset prices or flows. The supervisors can then take supplementary action to influence bank behavior, for example through direct action to restrain bank behavior, or by an increase in risk-dependent deposit insurance premia, for example.

Note that the indirect signaling mechanism needs to be complemented by effective official intervention, whereas the direct incentive mechanism is more self-policing. More subtly, market participants who are placed at risk can, through political or macroeconomic mechanisms, also influence the policy environment, including the rigor with which regulations are enforced. The more transparent and conspicuous the market signal, the less scope the supervisor will have for covert forbearance.

Both the monitoring and influence ability of both the market and the official supervisor may depend on national institutional characteristics, but it is unclear how rapid these abilities decline as we go down the institutional quality scale and which declines relatively more.

> 2 Interestingly, US studies which employ information on the timing of bank examiner downgrades show that equity prices have tended to fall (Berger, Davies & Flannery, 2000) following examiner downgrades but spreads on subordinated debt narrow some quarters after downgrades (De Young, Flannery, Lang and Sorescu, 2001).  The findings can be reconciled by assuming that shortly after the downgrade, the market discovers not only that (i) losses have been incurred (bad for equities) but (ii) corrective action is being taken (good for bond holders).

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