Journal of Financial Services Research 20:2/3 107±119, 2001 # 2001 Kluwer Academic Publishers. Manufactured in The Netherlands. The Faces of ``Market Discipline'' MARKJ.FLANNERY Box 117168, 321 Stuzin Hall, University of Florida, Gainesville, FL 32611±7168, 352±392±3184 E-mail: Flannery@u¯.edu Abstract Although ``market discipline'' has become a more popular notion among academics, bankers, and supervisors, the exact meaning of this term remains imprecise. The phrase is commonly used to incorporate two distinct phenomena:marketinvestors'abilitytomonitor(identify)changesinbankconditionvs.theirabilitytoin¯uence a®rm'sactions.Thisisanimportantdistinction,whichclari®eshowmarketinformationmightbeincorporated into the supervisory process. Key words: Regulation, security prices, subordinated debt. 1. Introduction Supervisory and academic interest in the application of ``market discipline'' to ®nancial supervisionhasrecentlyexpanded,ashasthevolumeofrelatedresearch.Theideasunder developmentaresuf®cientlynumerousandsubtlethataframeworkfortheirinterpretation ishelpful,perhapsevennecessary.ThisIntroductionaimstoplacetheConferencepapers into a broader framework of government ®nancial regulation. Moderncorporationsseparateownershipfrom de facto controlofthe®rm'sassets,and therefore require a system for governing the allocation of available resources. The academic literature has studied corporate governance mechanisms, focusing particularly on the incentives of various ®rm stakeholders. Numerous studies have considered how con¯ictingincentivescanimpedeshareholderwealthmaximization,andhowgovernance mechanisms can minimize the effects of agency and information problems (Bliss, 2000 provides a review). Despite a theoretical potential for dysfunctional outcomes, however, the corporate form of organization is dominant throughout the world, at least for large, capital-intensiveenterprises.Apparently,theproblemsassociatedwithinvestorcontrolare frequentlylessburdensomethantheadvantagesofcorporateorganization(tradedequity, limited liability, etc.). Although the Darwinian evidence for this conclusion is fairly evident in unregulated sectors, the issue remains less resolved where governments supplant market-based corporate governance. It is often said that the public has a strong interest in the ®nancial system's overall stability.The``special''characterofbankingderivesfromtworelatednotions.First,ifa bank's failure generates important external costs (e.g., ``contagious'' depositor runs or ®nancial instability), government might seek to reduce the number of failures through restrictive regulation. Second, a lender of last resort and (formal or conjectural) deposit