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January/February 1990, 
Vol. 72, No. 1
Posted 1990-01-01

Market Discipline of Bank Risk: Theory and Evidence

R. Alton Gilbert investigates the implications of deposit insurance reform proposals based on market discipline. Gilbert uses a simple theoretical exercise to illustrate how market forces could limit the risk assumed by banks under different approaches to reforming deposit insurance. He also summarizes the empirical studies of the effectiveness of market discipline to determine whether market forces actually could be expected to limit such risks. Under the current arrangements, the cost of resolving bank and thrift failures is borne largely by the taxpayer through the federal deposit insurance agencies. In the policy debate, which considers the flaws and potential alternatives to the present system, a number of economists have utilized a set of theoretical tools—called option pricing models—for analytic purposes.