However, market participants failed to sufficiently monitor or react to banks’ risk-taking behavior ahead of the crisis, partly due to the procyclical and incomplete information that they had been receiving<sup>14</sup> . In fact, quite the opposite seems to have happened – shareholders actively encouraged banks to take on greater risks in order to match or exceed the performance of their peers<sup>15</sup> . This type of herding behavior is well-exemplified by the statement of former Citigroup CEO Chuck Prince in an interview with the Financial Times in July 2007: “ _when the music stops, in terms of liquidity, things will be complicated. But, as long as the music is playing, you have got to get up and dance. We are still dancing_ ”.

Moreover, anecdotal evidence suggests that debt holders relied excessively on credit rating agencies and on the CDS market to monitor and control their bank exposures, both of which proved unreliable in retrospect. Even though some of the banks ultimately failed or were intervened because they were rapidly becoming illiquid<sup>16</sup> , there is little evidence that large uninsured depositors or counterparties were taking pre-emptive action by moving their holdings or reducing their exposures significantly in advance of such events<sup>17</sup> .

There is also some evidence that market participants’ incentives to monitor and discipline banks were blunted by too-big-to-fail considerations, especially after the arranged takeover of Bear Stearns by J.P. Morgan in which the debt holders and CDS counterparts of the former were protected. In fact, the aforementioned difference in pricing behavior across different bank securities may not be solely due to their position in the capital structure but could also reflect the market’s expectation of likely government support to prevent the default of systemically important banks. This perception may have given comfort to the holders of those classes of securities (e.g. senior debt) that would only lose if such an event materialized; this is most obvious in the case of Lehman Brothers, where the price of senior debt remained fairly steady throughout the crisis until it collapsed upon the bank’s default. The absence of a resolution regime for systemically important non-bank financial institutions in the U.S., including for bank holding companies, may also have led market participants to expect the authorities to keep such institutions afloat. By contrast, holders of capital instruments that would lose value even if no bank default took place – such as preferred shares – were more risk sensitive as illustrated by price movements in those instruments.

Finally, the MD literature recognizes the importance of governance (building block 4) as a necessary factor to align the interests of principals (stakeholders) and agents (senior management and the board of directors). In the specific case of banks, strengthening governance is essential given their opaque nature and public interest entity status, and is a ‘first line of defense’ in

> 14 More disturbingly, it seems that key counterparties did not sufficiently monitor and discipline banks even in cases where the relevant information was publicly available. See, for example, Frankel (December 2009) for an analysis of the 2007 failure of New Century Financial.

> 15 Hellwig (November 2008) argues that “ _market discipline as a mechanism of corporate governance [by shareholders] is intrinsically biased in favor of strategies that involve greater risk-taking_ ”.

> 16 For example, the demise of Bear Stearns prior to its arranged takeover has been attributed to the decision of other market players not to roll over short-term repos with it, resulting in a rapid loss of working capital.

> 17 Information on the evolution of deposits (Citigroup) and reverse repos (Bear Stearns and Lehman Brothers) over this time period was also collected. However, such information is less frequent (it is mostly reported on a quarterly basis) and did not provide sufficient granularity or direction to draw definitive conclusions.

11